Something for the Adventurous

Stocks beat bonds handily in 1996--except for one type of bond: emerging-markets debt.

The average total return of the 18 mutual funds in the emerging-markets bond category was a stunning 42% last year, according to fund tracker Lipper Analytical Services of Summit, N.J.

That gain occurred as market interest rates fell sharply in many countries, boosting the value of existing bonds. The price appreciation, added to the high yields on the bonds, produced the hefty total returns.

And with Third World bond yields still hovering at 10% or better, the funds could remain superior performers for quite some time, some analysts say.

Just keep in mind that emerging-markets bond funds aren’t for the faint of heart. Nobody can expect to earn double-digit returns without facing above-average dangers. “These bonds certainly carry higher risks,” says Michael Conelius, who manages the T. Rowe Price Emerging Markets Bond Fund in Baltimore. “The countries that issue them have been rated below investment grade for a reason.”

Such nations include most of those in Latin America, Eastern Europe, Asia and Africa. Although some corporate issues are available, most emerging-markets debt comes from national governments.

The diversified format of mutual funds helps to lessen the risks that any single bond issue that blows up could destroy a portfolio. But it won’t insulate shareholders from occasionally nasty price dips. For example, Fidelity’s New Markets Income Fund on two separate occasions within the last three years suffered numbing quarterly losses of more than 20%.

But people who can tolerate significant fluctuations might consider a small stake in an emerging-markets bond fund. Here’s why:

* Generous yields. Bond rates paid by emerging-market countries currently exceed that of U.S. junk corporate bonds--typically the highest-yielding U.S. bonds--by about 2 percentage points.

That translates into current annualized yields of anywhere from 7.2% to more than 9% on emerging-markets bond funds. In contrast, five-year U.S. Treasury notes now yield 6.40%.

* Market inefficiencies. Compared with the number of investment pros who specialize in U.S. government bonds, corporate issues and municipals, far fewer analysts comb through the bonds issued by Third World nations. This presents opportunities for fund managers to spot bargains.

“In the entire bond market universe, emerging-markets debt is the most neglected,” says Peter Wilby, a manager at Salomon Bros. Asset Management in New York.

* Relatively modest interest rate risk. If market interest rates should rise worldwide, lower-quality, higher-yielding bonds such as emerging-market issues may not be affected dramatically, because their yields are already high. Rather, their prices rise or fall more in response to factors affecting their credit-worthiness.

“What drives changes in the bonds’ yields are changes in the country’s economic and political fundamentals,” says Peter Lannigan, who runs the Phoenix Emerging Markets Bond Fund in Hartford, Conn.

The good news is that more developing nations are embracing free-market economic policies, in large part to attract Western money. “The larger emerging countries realize they need access to global capital markets,” Wilby says. “The way you get this is by improving your credit with fiscal discipline.”

* Modest currency risk. When the dollar rises against other major currencies, U.S. owners of mainstream foreign bonds such as those of Japan, Germany and Britain risk devaluation of their holdings.

But this isn’t a danger with most Third World bonds. “Most [emerging-market] borrowings are done in hard currencies, especially dollars, because these countries don’t have their own capital markets,” Lannigan says.

* Low correlations with other assets. For all of the above reasons, bonds issued by emerging nations tend not to move in sync with either U.S. stock or bond prices, which makes them a good diversification tool.

The big risks? Political shocks overseas, or the threat of a global recession, which could hurt the countries’ credit-worthiness.

In any case, most financial advisors say emerging-market bonds should be considered spice for a portfolio--not a core asset.

Russ Wiles is a mutual fund columnist for The Times. He can be reached at [email protected]

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Some Impressive Performers

Most emerging-markets bond funds have been around only a year or two, but they have performed very well over their short lives. Here are total 1996 returns on selected funds and current yields.

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1996 Current Fund % return Yield Phone Bear Stearns Emerg. Debt +41.0 8.0% (800) 766-4111 Fidelity Advisor Emerging Mkts +40.3 7.6 (800) 522-7297 Fidelity New Mkts Income* +41.4 7.7 (800) 544-8888 GT Global Income A +36.8 7.8 (800) 824-1580 Phoenix Emerg. Markets Bond* +54.4 8.9 (800) 243-4361 T. Rowe Price Emerg. Mkts Bond* +36.7 7.2 (800) 638-5660 Scudder Emerging Mkts Income* +34.6 9.1 (800) 225-2470

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* Indicates no-load fund.

Source: Lipper Analytical Services