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Taking a Look at Emerging-Market Bonds, Tax Questions

After my recent article on emerging-market debt, Steve Coletti asks: Do "the same asset allocation class distinctions between bonds and equity funds work for emerging-market funds -- i.e., bonds usually rise when equities fall."

"The short answer to your question is 'No,'" says Graham Stock, a vice president at Chase Securities' international fixed income department. "Emerging-market bonds usually fall when equities (in emerging markets or in the main financial centers) fall."

There are exceptions to the rule, but in general, when an emerging market is doing well economically, the government is better able to pay its bills, and at the same time, the outlook for equities is strong.

"The most direct explanation for this phenomenon is that the rally in U.S. Treasuries that usually accompanies a fall in equities represents a flight to quality," says Stock. "Emerging-market bonds are inherently more risky than U.S. Treasuries, and so they suffer from the flight rather than benefit from it." In both emerging and developed economies, equity markets tend to fall when prospects for economic growth deteriorate.

However, slow economic growth can have a much greater impact on an emerging economy because it "undermines the emerging market governments' ability to continue to service its debt and therefore pushes up the default risk for the bonds," Stock says.

Ironically, this year is an exception to this rule. The equity markets of emerging economies have produced pretty lackluster results this year, with a few notable exceptions. Emerging-market debt, however, has been a solid performer. The returns on emerging-market bond mutual funds as a category are up 10.6% this year, while emerging-market equity funds are down 20.6%, according to Morningstar.

Part of this can be explained by the high oil prices, which have helped improve the financial picture of the oil-producing emerging markets. At the same time, most stocks in emerging markets are down because of concerns about the impact of an economic slowdown in the U.S. -- concerns of which, of course, partly stem from the high oil prices. However, many emerging markets that are not oil producers, such as Brazil, are in pretty good economic shape with minimal concerns about the risk of default.

Moving on, after reading my column on the dividend and yields of iShares, Brandan Imen asks, "If (a mutual) fund pays capital gains taxes, does it mean that I don't have to pay taxes on my dividend earnings at the end of the year? If I do so, I am paying double tax?"

Feeling overwhelmed by tax questions -- an area I don't like to think about, let alone one that I have mastered -- I asked Tracy Byrnes, TheStreet.com's excellent columnist on tax issues. Mutual funds are "pass-through entities," she says, meaning they pass through everything, both gains and losses, to shareholders so mutual fund shareholders must still pay tax on dividends. Check out her story in October for more detail on how it works, as well as a follow-up piece she wrote.

Finally, in the spirit of following up, it is worth noting that the merger of Latin American Internet portal El Sitio (LCTO) with media and Internet provider Ibero American Media Partners, the rumors of which I discussed last week, did occur.

El Sitio was a classic buy-on-the-rumor, sell-on-the-fact case, however. After rising 17% on rumors of the deal last Friday, the stock has been flat or slightly down, even though the deal certainly helps El Sitio.

Nonetheless, the deal is indicative of the beginnings of consolidation of the Latin America Internet sector. Look for Starmedia (STRM - Get Report) to find a big partner next. It had a pretty good week on its own, though, rising 54% after beating estimates on its third-quarter earnings.

David Kurapka's Global Portfolio column appears Mondays, Wednesdays and Fridays on TSC. In keeping with TSC's editorial policy, he does not own shares in any companies or mutual funds mentioned in this column. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send it to David Kurapka.

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