NEW YORK ( TheStreet) -- Shareholders, excited about the prospects for countries such as Brazil and China, have been pouring cash into emerging markets stock funds. But the stocks can be dicey, as investors learned in 2008 when these funds lost 54%, according to Morningstar ( MORN ). For a steadier bet on developing countries, consider mutual funds that hold their bonds, which have proved less volatile than stocks during the crashes that have plagued emerging markets. Emerging markets bonds are one of the top-performing fund categories of recent years. In the 10 years through June, these funds returned 11% annually, outdoing stock funds that invest in the same countries by more than a percentage point. They beat every other fixed-income category by a wide margin. A bright outlook for emerging economies is fueling gains. While the developed world struggles to cope with the credit crisis, many emerging economies are in healthier shape because their consumers and banks didn't take on excessive debt. Countries such as Indonesia and Chile seem poised to grow faster than the U.S. for years to come. The picture for emerging bonds began improving after the group suffered severe setbacks in the 1990s. When financial markets in Russia and Asia collapsed in 1998, the bond funds recorded their worst year ever, losing 26%. In 1999, the depressed bonds began a remarkable bull market, producing double-digit returns for eight straight years. The bonds soared as governments in emerging economies reformed their ways. Once troubled by deficit spending and heavy debt loads, countries in Latin America and Asia tightened their belts. Governments balanced budgets and sought to control inflation. With global trade booming, emerging economies prospered. Instead of being debtors, many countries became creditors with big holdings of foreign currencies.
The credit ratings of emerging countries improved along with their balance sheets. A decade ago, bonds from emerging economies were typically considered speculative issues with junk ratings. Since then, many bonds in the emerging markets benchmarks have been upgraded by Standard & Poor's to investment grade. These benchmarks are now dominated by investment-grade issuers, including Russia, Mexico and Brazil. Many emerging-markets bond funds come with average credit qualities of BBB, the lowest investment-grade rating awarded by Standard & Poor's. Improved credit quality has produced dramatic changes in the bond markets of these countries. Instead of appealing primarily to aggressive investors, the bonds attract bids from pensions and other conservative institutions that had previously avoided the risky issues. The institutions have helped to stabilize the markets and boost prices. Have these bonds become too expensive in the wake of a long rally? Probably not. Many funds in the category yield more than 7%. That's an attractive payout at a time when 10-year Treasuries yield 3.5%. Emerging markets bond funds are sometimes compared to U.S. high-yield bonds, which are rated as junk. In fact, the emerging funds have proven less volatile because of their improved credit quality. While high-yield funds lost 26% in 2008, emerging funds dropped 18%. For a steady option, consider the MFS Emerging Markets Debt Fund ( MEDAX). During the 10 years through July, the fund returned 15% annually, outdoing 92% of its competitors. Portfolio manager Matthew Ryan limited losses during 2008 by emphasizing bonds from stable investment-grade countries, including Chile and Panama. He steered away from shakier issuers, such as Pakistan and Ukraine.
Ryan has been taking on more risk lately, buying issues from Argentina, which yield more than 14%. "Argentine bonds have gotten too cheap relative to the risk," he says. Another strong performer is the TCW Emerging Markets Income Fund ( TGEIX), which returned 13% annually during the past decade. To limit risk, portfolio manager Luz Padilla has 75% of the fund's assets in investment-grade securities, and the portfolio has an average credit quality of BBB. While some funds focus on government bonds, TCW owns a mix of government and corporate issues. A favorite issuer is Globo Comunicacao, a leading Brazilian broadcaster. "We should see positive economic growth in some emerging economies this year, and that will help investment-grade corporate bonds," says Padilla. For a broadly diversified fund, try the T. Rowe Price Emerging Markets Bond Fund ( PREMX), which has returned 12% annually for the past decade. Besides holding positions in Brazil and other larger economies, the fund owns stakes in frontier markets, such as Angola, Serbia and Gabon. Portfolio manager Michael Conelius says rising commodity prices are boosting bonds in many developing countries. He is particularly keen on the outlook for Ghana. "The nation's main exports of cocoa and gold have held up well throughout the global downturn, and recent oil discoveries should further bolster the economy," he says. In a contrarian move, Conelius owns bonds of Iraq. He says that the country has little debt and strong income from oil exports. He expects that increasing foreign investments will bolster Iraq's oil fields. That should help stabilize the country's bonds for years to come.