NEW YORK (TheStreet) -- Worried about the uncertain economic outlook, investors have been dumping emerging market bonds and racing to buy Treasuries. During the past three months, emerging market bond funds have lost 3.4%, while long government funds have gained 19.8%, according to Morningstar.

But not all emerging bond funds have suffered equally. During the past three months,

Fidelity New Markets Income

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about broke even. The fund avoided trouble by following the cautious approach favored by portfolio manager John Carlson. The Fidelity manager shuns the lowest-quality bonds and emphasizes government securities that are issued in dollars -- not in foreign currencies. The dollar bonds often prove resilient in downturns. "Our first rule is to play good defense and avoid blowups," says Carlson.





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Is the recent turbulence a sign of trouble to come in the emerging markets? Probably not, says Carlson. He says that the emerging markets were pulled down by concerns about debt problems in Europe. But the panic has subsided, and the bonds have been recovering as global markets have rebounded. Now the bonds seem poised to deliver decent returns, he says. "The fundamentals of most emerging countries are in really good shape," he says.

Strong Growth

Fidelity and other emerging bond funds have attracted bigger followings lately. During the past year, investors poured $14 billion into the funds. That's a huge flood of cash for a category that only has $43 billion in total assets. Investors have been attracted by the improving outlook for emerging markets. At a time when the U.S. and Europe struggle with crushing debt burdens, many countries in Asia and Latin America have solid balance sheets and rapidly growing economies. As their prospects have improved, emerging market bonds have strengthened. During the past three years, emerging bond funds have returned 17.3% annually, ranking as the top-performing fixed-income category tracked by Morningstar.

Besides offering a chance to benefit from growing economies, emerging bonds also provide competitive yields. Emerging bond benchmarks yield around 6.0%, an attractive payout at a time when 10-year Treasuries yield 2.18%.

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.

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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

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. 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.

Cirmani says that in coming years the emerging economies are likely to grow faster than the U.S. That should enable the local currencies to strengthen against the dollar. "The emerging markets will continue to have an edge," he says.

Should you buy a local-currency fund or one that holds dollar bonds? That depends on your view on the dollar and you appetite for risk. Dollar bears might prefer a local-currency fund. But to build a diversified portfolio, consider holding two funds, one specializing in dollar bonds and a second that focuses on local-currency issues.

Another approach is to buy a fund that owns both kinds of bonds. A fund that holds a mix is

Payden Emerging Markets Bond

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. During the past five years, the fund has returned 7.6% annually, outdoing 56% of competitors.

The fund holds both local-currency and dollar bonds from Indonesia, says Payden strategist Arthur Hovsepian. The bonds are rated BB, one step below investment grade, but the outlook is improving. The country is on the path to winning an investment-grade rating. That should help to boost the bond prices.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.