Emerging-Markets Bonds: A Good Source for High Income

Like most corners of the bond market, emerging-markets bonds have experienced a fine run in recent years as income investors have flocked to anything and everything that yields more than Treasuries. But John Carlson, who manages Fidelity New Markets Income (symbol FNMIX), a member of the Kiplinger 25 that specializes in emerging-markets debt, says he's still finding opportunities.

Carlson describes his investment process as a "mosaic approach," meaning he'll gather a lot of information from a variety of sources to build an investment thesis. Sometimes that means conducting conventional research trips, such as visiting with a country's bank executives and government officials, says Carlson, who fielded a phone call from me during a stop on a six-hour bus ride across Ghana. But he has also gone to such lengths as trying to open a personal bank account and buying a car in particular countries to get a feel for the local economy.

To hold down risk, Carlson generally keeps about two-thirds of his fund's assets in debt that's issued by emerging-markets governments and denominated in U.S. dollars. He uses the other third to try to juice returns, and he has the leeway to invest in corporate bonds, distressed debt, bonds issued in foreign currencies and even a bit in stocks. However, he never holds more than 20% of New Market Income's assets in non-dollar investments, corporate bonds or stocks.

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That said, investors ought to recognize that emerging-markets bonds aren't the high-octane investments they once were. "When you bought emerging-markets bonds 20 years ago they were highly speculative, and you got paid for that risk," Carlson says. Today, many developing nations look more financially stable than some developed markets, but the yields are lower, too, he says. New Markets Income currently yields 4.0%.

Today, Carlson likes the debt of some western African frontier markets, meaning countries that aren't yet developed enough to count as emerging markets. He favors Ghana, Nigeria and the Ivory Coast, where he says favorable demographic trends, large commodity resources and the availability of cheap credit have the potential to drive economic growth. "West Africa is a bit undiscovered still," he says.

He also favors government bonds issued by Turkey and denominated in Turkish lira. He says the country has improved its trade deficit in recent years and reduced the volatility of its currency. Plus, short-term Turkish bonds yield an attractive 6%, he says.

Over the past ten years through March 18, New Markets Income returned 11.7% annualized, beating 90% of funds that invest in emerging-markets bonds (Carlson has been at the helm since 1995). Although the fund has lost 1.4% so far this year, that beat the 2.1% loss for its benchmark, the JPMorgan Emerging Markets Bond Index Global. Carlson says those drops were driven by the rise in interest rates this year on long-term U.S. Treasuries (bond prices move inversely with interest rates). Investors typically use Treasuries as a yardstick in determining emerging-markets bond prices, which means that if Treasury bond yields rise, yields will generally rise in developing markets.

Carlson says those strong long-term returns aren't indicative of a bubble in emerging-markets bonds, but rather show how much progress has been made in the underlying economies. "We've come a very long way on the back of a very good story, which is the improvement in these countries' creditworthiness," Carlson says. He says about two-thirds of the countries in his investment universe are now rated investment grade, meaning triple-B or higher.