Safe Harbor in Emerging Market Debt?

Fear not emerging market debt any longer, investors. In the 1990s, this briar patch of the bond market was as hazardous as a minefield, but the improving quality of issuers and their offerings and a decline in price volatility have made it safer ground. Now, “emerging market debt could have a role in even the most conservative portfolios,” says Lord Abbett market strategist Milton Ezrati.

Discipline has come to the once unruly markets of rapidly developing countries, Ezrati says. More governments have shunned inflationary monetary policies and irresponsible fiscal actions that worried bond investors. Emerging nations’ efforts to tame inflation and build cash reserves has instilled more confidence among investors. “Inflation rates among emerging economies have dropped from annual rates of 15%, 20% and 25% during the late 1990s to around 5% on average,” Ezrati says.

Emerging market debt has also improved in quality. More than 44% of the market value of the J.P. Morgan Emerging Market Bond index is investment-grade debt, Ezrati says, up from 30% in 2002 and only about 5% in the late 1990s. As the quality of the debt has improved, yields have shrunk because there is less risk of default. “Emerging market spreads doubtlessly will gyrate back up at some point,” Ezrati says, but “the issuers of this debt are not as dangerous as they once were.” The volatility of emerging- markets bonds is barely higher than that of high-yield bonds in the U.S., he says.

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Bond investors have certainly noticed the progress. Last year, a record $6.2 billion flowed into emerging-markets debt funds, according to Emerging Portfolio Fund Research.

Closed-end funds usually offer a way to buy emerging market debt with a margin of safety. Unlike traditional, or open-end, funds, closed-end funds issue a fixed number of shares. Those shares trade like stocks, but they can sell for more or less than the assets the funds hold. That means you can sometimes buy closed-end fund shares at a discount to the value of their underlying holdings.

As of April 5, in fact, closed-end funds that specialize in emerging-markets bonds traded, on average, at a 7% discount to net asset value (NAV), according to fund research firm Lipper. Discounts for a number of closed-end developing-market bond funds have grown because a lot of these funds have cut dividends, says Wachovia Securities analyst Mariana Bush.

The simplest way to add emerging-market debt to your portfolio is through an open-end fund. Perhaps the best choice is Fidelity New Markets Income(symbol FNMIX). John Carlson has run the fund since 1995. He buys a broad range of emerging-market debt, preferring countries that attract direct investment from foreigners. Over the past ten years through April 1, the fund returned an annualized 12%. That’s an average of nearly one percentage a year higher than the typical open-end emerging-market bond fund. New Markets Income yields 5.7% and has a below average expense ratio of 0.90%.