Welcome to the bandwagon. Assets in open-end and exchange-traded emerging-markets bond funds have more than quadrupled from the start of 2010, ballooning to $95 billion in assets as of February 2013 from nearly $20 billion. That interest has spurred fund companies to launch a wide variety of new strategies.
Most of the older funds in that group focus mainly on hard-currency sovereign or quasi-sovereign bonds, those issued in dollars rather than the currency of their country of origin. Historically, dollar-denominated issuance made up the preponderance of these funds' investment universe, as this was the only viable way for countries with dicey fundamentals to gain access to capital. That dynamic has shifted over the past several years, after many maturing emerging markets have cleaned up their finances and have continued to exercise prudent fiscal and monetary policy. That has led to the development of robust domestic bond markets in many countries. In fact, local-currency markets' share of the entire emerging-markets fixed-income universe now tops 80%. Meanwhile, in the dollar-denominated market, emerging-markets corporate bonds have taken up an ever-greater share of new issuance, between 60% and 80% in each year since the global financial crisis.
Many of the category's recent fund launches have sought to capitalise on one of these trends. Nearly half of the funds introduced in the past three years have either a specific emerging-markets local-currency or corporate focus, leaving the emerging-markets bond category divided among hard-currency, local-currency, and corporate offerings. With the exception of a few specific region-focused funds, the same is true for the emerging-markets bond exchange-traded funds available. That complicates the choice for investors who want to have emerging-markets bonds in their overall asset allocation but don't have a strong view on which part of the market to play. Also, the relatively short life of most local-currency and corporate emerging-markets bond funds doesn't give investors much history by which to judge managers' skill. That may partly explain why the category's oldest local-currency bond fund, PIMCO Emerging Local Bond, (
rated Bronze by Morningstar analysts) is also its largest at $15 billion in assets.
The category's older hard-currency-focused funds have also attracted plenty of new money in recent years—the $7.5 billion MFS Emerging Markets Debt (rated Bronze by Morningstar) has continued to receive some of the highest levels of inflows over the trailing 12 months, for example—but the shifting investment landscape has posed challenges for the old guard. Some have added small stakes in corporates and local-currency debt in recent years, but they don't have the flexibility to make sizable shifts among these sectors as valuations may warrant. Some of these teams also haven't invested in the research resources to the same extent as certain competitors that a higher allocation to corporate and local-currency bonds demands.
Less-constrained total-return approaches that allow investment managers greater flexibility to invest across emerging-markets bond sectors may offer the best solution for fund investors who don't want to micromanage their sector allocation decisions. So far, such strategies are in short supply, but that could be changing.
A version of this article appeared in the April 2013 edition of Morningstar FundInvestor.
