The Hunt for Higher Yield: Investors Pour into Emerging Market Debt

The never-ending hunt for higher yield is leading investors to bet record amounts on emerging market debt.

In just the first two weeks of 2012, governments of undeveloped economies from Asia to Africa sold more than $30.6 billion in dollar-denominated bonds according to Bloomberg News.

That's up from roughly $19.9 billion in the same period last year and the most since 1999, when Bloomberg began collecting data.

Typically, investors shun emerging market bonds during times of uncertainty in favor of "safer" assets like gold and U.S. Treasuries.

But that has started to change.

The Big Move Into Emerging Market Debt

In fact, investor demand is overwhelming supplies as orders have outstripped the amount of bonds being sold.

During a recent auction, the Philippines received $12.5 billion of orders for $1.5 billion of 25-year bonds, pushing the yield down to a record-low 5%. Indonesia sold 30-year bonds at a record-low yield of 5.375% and Colombia sold $1.5 billion of 29-year bonds at 4.964%.

Analysts say the debt crisis in Europe, along with record low yields on U.S Treasuries, has investors on the hunt.

They are now buying the debt of undeveloped nations like Indonesia, Mexico and Brazil, even though credit-rating firms rank them as more risky than their European counterparts

"What we're seeing is a re-evaluation of sovereign-credit risk, increasingly being driven more by fundamentals than by classifications," Eric Stein, a portfolio manager at Eaton Vance Corp. (NYSE: EV) told The Wall Street Journal.

According to the J.P. Morgan Emerging Markets Bond Index, investment-grade sovereign emerging-market bonds are yielding an average of 4.7%.

By contrast, Italian 30-year debt yields 7%, while Spanish 30-year debt yields 6.1%.

One reason emerging market bonds are attracting interest is...

that investors recognize the difference between the debt problems faced by Western economies and healthier emerging markets.

The debt levels plaguing the world's largest and most developed economies - like the United States, the United Kingdom and France - exceeds 70% of their gross domestic product (GDP) according to the International Monetary Fund.

By comparison, many emerging market economies have debt-to-GDP ratios of less than 40% -- including Brazil and Mexico - the two undeveloped economies that have been the biggest sellers.

"The Europeans and the Americans need to borrow a lot more than the Asian countries and they use the money for the wrong thing: to fund somebody's consumption," Endre Pedersen, director for fixed-income investments at Manulife Asset Management told Bloomberg.

Emerging Market Upgrades

Indonesia is benefiting from a December promotion to investment-grade status by Fitch Ratings Inc. after losing that status 14 years ago during the Asian financial crisis.

The Indonesia upgrade opens its debt markets to a number of bond funds that had been prohibited from investing in the country. That makes Indonesia an alternative investment opportunity for a whole swath of investors.

Most analysts are speculating that other small economies will soon get the same treatment. Meanwhile, Fitch and Standard and Poor'searlier this month downgraded the debt outlook for France and 12 other euro countries.

Still, some see emerging market debt as a reasonable alternative to the tiny yields offered by Treasuries and other government-related debt.

U.S. government 10-year notes traded Wednesday at a record low 1.87%. At an auction in early January, Germany sold $4.96 billion of debt that had an average yield of negative 0.0122%, the first time that yields on German debt moved into negative territory.

At those rates it's not hard to see why many investors are willing to step out of their comfort zones to get a better deal.

How to Invest in Emerging Market Debt

Indeed, some funds are delivering appetizing returns.

Among the top performing funds, the Columbia Emerging Markets Bond Fund (MUTF: RSMIX) returned a tasty 9.63% over the last 12 months.

But most investors aren't willing to bet on single country funds, instead choosing funds that have access to multiple countries.

In fact, emerging-market exchange traded funds (ETFs) are the only way for U.S. investors to access some countries, Matt Tucker, head of iShares fixed income strategy told MarketWatch.

And there's yet another angle for investors to like about emerging market debt - in addition to cleaner balance sheets, undeveloped economies have potential to deliver gains from stronger currencies.

By investing in bonds denominated in local currencies of emerging markets, investors can also benefit from the appreciation of the currency on top of the income from the bond.

Investors have several options including WisdomTree's Emerging Markets Local Debt ETF (NYSE: ELD) and the Market Vectors Emerging Markets Local Currency Bond ETF (NYSE: EMLC).

Both track the performance of debt issued in local currencies of more than a dozen developing countries including Brazil, Mexico, and Russia.

Over the past six months, both ETFs have gained about 5%.

With the Fed set to hold rates near zero into 2014 you can expect this hunt for yield to continue.

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