1. GMO Emerging Market Debt III GMCDX

2. TCW Emerging Market Income I TGEIX

3. MFS Emerging Markets Debt MEDGX

4. Fidelity New Markets Income FNMIX

5. T. Rowe Price Emerging Mkts Bd PREMX

The phrase “emerging markets” does not normally bring to mind the image of bonds – rather we think of the far-flung stock markets of Asia, Latin America and other dynamic, developing and often volatile markets. In fact, however, fixed income was an emerging markets play before that term ever even came into vogue. In the 1970s one of the big games in international finance, and one in which almost all giant banking institutions of the day were involved, was called the “LDC debt market”. LDC stood for “less developed countries”, and much of the action was centered in Latin America, partly because the big US banks of the day like First National City Bank (today’s Citigroup) and Chemical Bank (now subsumed into JPMorganChase) had taken big bets on loan exposure in these countries.

Like many financial crazes this one involved more than its share of tears for many involved, but market conditions evolved and in the 1990s a new wave of emerging markets debt came into being. Unlike the earlier generation of LDC loans these debt obligations are able to be packaged into pooled asset vehicles, and many have found their way into the portfolios of mutual funds that are as easy for individuals to access as are mutual funds in any other asset class.

As fixed income investments these funds (predictably) tend to be more volatile than other types of bond funds, but they are quite a bit less volatile than emerging markets equities and have demonstrated attractive risk-adjusted return characteristics over the past 15-odd years.

Steven Whittington

Let’s meet this week’s Jem5 investor, Steven Whittington. Steven is 69 years old and four years ago he retired from a long career working for a major New York bank that he originally joined back in the 1960s, somehow surviving the twists and turns of the industry, the markets and his own company all those years. Steven well recalls the era of LDC banking, and spent many a business trip touring Brazilian rubber plantations, Venezuelan oil refineries and Chilean copper mines to conduct due diligence for the loans his bank was planning to extend to the local companies or governments (which in those days of the State-Owned Enterprise were often one and the same).

Steven’s portfolio is well diversified and prudently reflects his planning and income needs for a comfortable retirement (he is married with three children who have all graduated from college and are working and supporting themselves). He still likes to follow business and economics, and not too long ago came across an article in one of his favorite financial journals about emerging markets debt. He was interested to see how the risk-return considerations have changed substantially – liquidity is readily available through the mutual fund platform and the funds are able to diversify and hedge across a range of exposures including country, industry, currency (local, US dollar or other), interest rate structure and credit quality. He decides to set up a Jem5 profile to evaluate candidates for allocation to his portfolio.

Comments: What should be considered in regard to the scores above is that the risk-return characteristics are somewhat atypical for fixed income – notably the double-digit standard deviation numbers. Emerging markets bonds are by no means a “core” bond investment – they are much too volatile to fulfill that role. In fact some portfolio managers consider them to be more appropriately classified as “alternative” investments rather than a component of the bond portfolio. In any event, the combination of low-double digit standard deviation and high-single / low-double digit returns over the past ten years – along with generally lower levels of correlation to either conventional bonds or equities – makes this an attractive asset class in comparison to others over the same time periods.

Additionally, it should be noted that while the fees for EMD funds are somewhat higher than for other types of bonds, the expense ratios  tend to be below 1% and thus competitive relative to various equities profiles.

Steven feels comfortable with the economic characteristics of these funds and, after giving some analysis to the details contained in the Jem5 rankings, opts for the #1 fund for his profile, the GMO Emerging Markets Debt fund.

*Note: Jem 5 is a regular feature on the Jemstep blog which represents our top mutual fund ratings for unique investor profiles. For more information, read our first post in the series.

TAGS: bond funds, Jem 5, mutual fund ratings