The Next Huge Emerging-Market Craze

Investors are already quite familiar with the virtues of emerging-market stocks in red-hot growth areas over those of developed countries with sagging economies. But as stock markets around the world have seen lackluster performance, many investors are looking to emerging-market countries for an entirely different reason: to cash in on their bond markets.

Last week, ETF industry leader iShares released a new foreign fixed-income fund, the iShares Emerging Markets Local Currency Bond Fund (NYS: LEMB) . Competing against the WisdomTree Emerging Markets Local Debt Fund (NYS: ELD) , which started trading in 2010, the iShares ETF is just the latest example of how financial companies are trying to give investors the exposure they crave to higher-income investments.

Get outta here
Investors face two problems. On one hand, Treasury yields are near record lows, with the 10-year Treasury having fallen below 2% recently before bouncing back somewhat. The domestic situation is so bad that many investors have chosen to move into dividend-paying stocks as an income-producing alternative, even though it means taking on more overall risk in their investment portfolios. Yet for many, raising stock exposure simply isn't consistent with their risk tolerance, and so they need to look for other choices.

At the same time, the risk of a continuing drop in the value of the dollar is very real. Inflation has reared its ugly head in the past year, with the CPI having risen nearly 4%. Although the situation in Europe briefly pushed the dollar upward in a flight away from the endangered euro, any solution to sovereign debt woes on the Continent would likely restore the long-term trend against the dollar. The recent S&P downgrade of U.S. debt, along with the Federal Reserve's promise to keep rates low until at least mid-2013, also weigh against the dollar's strength in the coming years.

To address those problems, emerging-market bonds look very attractive. With Brazil taking steps to fight inflation, interest rates there are much higher than in the U.S. -- and when you add the currency appreciation of the Brazilian real, total returns for U.S. investors in Brazilian bonds have been quite strong even considering the recent taxes the government there has imposed on foreign investors. Moreover, in stark contrast to previous conditions, it now appears that many emerging markets are far more economically stable than their developed-world counterparts. That explains the reason for the new ETF; the popular iShares JPMorgan USD Emerging Markets Bond ETF (NYS: EMB) gave investors half of what they wanted, but didn't provide local-currency exposure to hedge against a dollar decline.

Look out below
However, those looking to emerging market bonds to save them need only look at their stock counterparts to see the dangers in the developing world. Baidu.com (NAS: BIDU) , for instance, has taken investors on a roller-coaster ride, with the stock down more than a quarter from its highs just a few months ago on fears about the Chinese government crackdown on the corporate structure it uses. Petroleo Brasileiro (NYS: PBR) and Vale (NYS: VALE) have done far worse, with their stocks teasing 52-week lows on combined concerns about a global economic slowdown reducing demand for energy and materials as well as possible domestic troubles. And in India, Tata Motors (NYS: TTM) hasn't seen the big expansion in production that investors had hoped, which also pushed the stock to new yearly lows in recent weeks.

Similarly, emerging-market debt has the same risk factors. Although emerging countries enjoy relative political and economic stability right now, there's no guarantee that favorable conditions will persist. Moreover, moves in foreign exchange rates can quickly eliminate any yield advantage from emerging-market bonds. If you invest in emerging-market bonds, you shouldn't count on getting the double-boost of high yields and a falling dollar forever.

Worth a look
Despite all those caveats, however, the idea of diversifying your fixed-income exposure with emerging-market bonds makes just as much sense as buying stocks from emerging regions to broaden your portfolio. As long as you understand the risks involved, putting a portion of your fixed-income allocation into international bonds could help boost your returns over the long run.

ETFs are often the easiest way to invest in tough-to-access markets like emerging-market debt. Read about three more ETFs that could pave the way to profits in the Fool's special free report "3 ETFs Set to Soar During the Recovery."

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

At the time this article was published Fool contributor Dan Caplinger has never been much of a craze-follower. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Petroleo Brasileiro and Baidu.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy works around the world.

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