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Finding Jewels in Emerging Markets Bond Funds

Carlson says that a major reason to own emerging bonds is to diversify fixed-income portfolios. His fund has holdings in more than 50 countries, including Argentina, Ghana, and Turkey. Those countries all present risks, but the outlook for the U.S. is also uncertain, says Carlson. "Instead of having all your holdings in one country, it makes sense to diversify globally," he says.

Emerging market bonds make sound diversifiers because they don't necessarily move in lockstep with Treasuries. As the financial crisis unfolded, investors sold emerging market bonds and fled to the safety of long Treasuries. During 2008, long government funds returned 27.7%, while emerging market bond funds lost 17.6%. But then the roles reversed as investors gained more confidence and interest rates rose. In 2009, long government funds lost 17.5%, while emerging bond funds gained 32.4%.

Carlson's broadly diversified approach has proved fruitful. During the past decade, the fund has returned 11.9% annually, outdoing 74% of peers. But Carlson doesn't excel every year. In 2010, he trailed most competitors as prices of low-quality bonds soared and local currencies appreciated against the dollar.

Foreign Currencies

While Carlson focuses on bonds that pay interest in dollars, some competing funds hold issues that are denominated in foreign currencies. Such local-currency funds own bonds that pay interest in Russian rubles, Mexican pesos, or Thai baht. When the currencies rise against the dollar, the value of a local-currency portfolio appreciates for U.S. investors. If the currencies fall, the local-currency funds will suffer. In recent months, the dollar has strengthened. That has helped the Fidelity fund and other dollar-based portfolios.

Despite the recent volatility, local-currency bonds can provide compelling yields and diversification, argues Michael Cirami, portfolio manager of Eaton Vance Emerging Markets Local Income (EEIAX). Local bonds yield more than dollar bonds. Cirami says that five-year Turkish bonds issued in dollars yield 4.0%, while comparable securities denominated in Turkish lira yield 8.7%. Investors demand the extra yield to compensate for the currency and inflation risks that could erode returns of local bonds.

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