Opportunity in Emerging Markets Debt?

Despite some bumps along the way, emerging market bonds have delivered average annual returns of 11.5% over the past 10 years ending on September 30, 2009. That ranks among the best performance of all major asset classes for that period as measured by the J.P. Morgan Emerging Market Bond Index Global (EMBI Global). Furthermore, based on this same index, these bonds have delivered a 26.3% cumulative return year-to-date as of September 30, 2009.¹

While past performance is no guarantee of future results, including investments in this asset class in a portfolio has the potential to provide income, inflation protection, and diversification for the right investor. Because the returns for emerging market bonds are relatively volatile when compared with, for example, U.S. government bonds, the asset class is most appropriate for long-term, risk-tolerant investors.

Although many investors may be familiar with emerging market stocks, emerging market bonds may be a relatively unknown asset class. According to Morningstar, there are just 31 mutual funds and exchange-traded funds (ETFs) within the emerging market bond category. In contrast, there are 141 funds and ETFs within the emerging market stock category.²

Before we take a look at today’s emerging bond market, we'll compare these bonds with emerging market stocks, discuss their investment risks, and review some history.

Comparing bonds and stocks
Over the long haul, emerging market bond mutual funds have been less volatile than emerging market stock funds because their stream of interest income has helped to smooth returns. In fact, according to Morningstar, over the past 15 years ending on March 31, 2009, diversified emerging market bond funds suffered double-digit losses in 12 rolling three-month periods. This compares favorably to emerging market stock funds, which suffered double-digit declines in 33 rolling-three month periods. In some cases, there were distinct differences in the severity of these declines. For example, emerging market bonds declined almost 11% in 2008 while emerging market stocks tumbled 53%.³

This track record of avoiding more serious declines has enabled emerging market bonds to outperform emerging market stocks over extended periods. For the 10-year period ending September 30, 2009, emerging market bonds had average annual returns of a little more than 11%, compared with 3% for emerging market stocks.³

Another notable difference between emerging market bond and stock funds is regional exposure. According to Morningstar, while both types of funds typically provide significant exposure to Brazil, Mexico, and Russia, in general emerging market bond funds provide less exposure to Asian countries such as China, South Korea, and India. Conversely, emerging market bond funds can potentially provide exposure to "frontier" countries (for example, Venezuela), in which traditional emerging market equity funds may not invest.²

Investment risks
Bonds of all types from the fast-growing economies of developing nations carry higher credit risk—the risk that the issuer will not be able to make principal and interest payments—than bonds issued by more economically developed nations. Even in countries where the sovereign debt is rated investment-grade, such as Brazil and Mexico, government bonds tend to be on the low end of the investment grade scale. Many other developing nations’ bonds are rated below investment grade. Most corporate securities are rated by several of the major rating agencies. For example, securities rated Baa and BBB or higher by Moody's and S&P, respectively are considered investment-grade bonds.

Investors in these bonds also face the risk of currency fluctuation. If the bonds are issued in the local currency rather than U.S. dollars ("dollar-denominated"), shifts in foreign exchange rates may undermine the dollar value of overseas investments.

For these and other reasons, among the major fixed-income asset categories, the volatility of emerging market bonds is second only to corporate high yield-bonds.²

Lessons learned 
As the market for emerging markets debt has developed over the past 25 years or so, there have been several crises that have tested investors' faith. In 1997, a crisis among Asian banks led to widespread problems. In 1998, Russia defaulted on its bonds. More recently, Argentina and Ecuador defaulted on their bonds, and some Eastern European nations are currently in crisis mode.

Central bankers around the world have implemented reforms, however. Countries that were extremely risky in the past now have more independent central banks, floating currency policies, and/or fiscal restraint. Many developing nations also took advantage of the huge run-up in commodity prices (oil and precious metals) to build sizeable cash reserves that have made it easier to weather the most recent global credit crisis. In addition, support from the International Monetary Fund (IMF) has been instrumental in preventing the type of catastrophic chain reaction that has marked previous crises. As a lender of last resort, the IMF plays an important supporting role by providing loan programs.

“There have been a lot of lessons learned over the past 20 years,” says John Carlson, manager of Fidelity New Markets Income Fund (FNMIX). “The difference this time around was that a lot of these countries were better positioned to withstand the downturn.”

Opportunities in today’s market
Emerging market bonds—like any bonds—are sensitive to interest rate fluctuations. Therefore, when interest rates rise, bond prices typically fall. This effect is usually more pronounced for longer-term securities. Today’s historically low global interest rates have helped support the market for emerging market debt by making it cheaper for countries to issue new debt. Additionally, a weakening U.S. dollar has made it easier for developing nations to repay their outstanding dollar-denominated debt. With these trends in place, emerging market debt, as measured by the J.P. Morgan Emerging Markets Bond Index Global, has performed admirably over the one-year period ending September 30, 2009, with a gain of 18.7%.

But what happens if the global economy recovers, interest rates rise, and inflation surges? In this case, emerging market bond prices may fall. However, the higher coupon rates on these bonds will provide some cushion, especially when compared with other, lower-yielding types of bonds.

Additionally, because many developing countries are rich in commodities and natural resources, their economies may benefit if investors turn to these assets for inflation protection.

How to invest
Due to the complexities involved in researching and trading non-U.S. securities, mutual funds offer the most practical way for most individual investors to gain access to emerging market debt.

Emerging market bond funds invest primarily in the sovereign debt of developing nations. Just as the U.S. government issues Treasury bonds to finance its operations, countries like Brazil, Russia, and Mexico issue dollar-denominated debt. Additionally, many developing nations operate substantial local government bond markets.

In evaluating a fund investing in foreign bonds, consider its exposure to local currency risk. Some funds, such as Fidelity New Markets Income Fund, invest primarily in dollar-denominated debt, while others may allocate more assets to local currency bonds, which means they are more volatile for U.S. investors.

When sizing up potential candidates, also take into account the experience level of the fund manager. For example, John Carlson has been managing New Markets Income since 1995. He has firsthand experience managing the fund through the infancy of this asset class and has learned valuable lessons along the way. "Having worked in the investment field throughout the extreme markets of the 1970s and each market dislocation since," says Carlson, "my experience combined with our extensive global research here at Fidelity provides the clarity we need to build positions with confidence, despite the volatility some of these economies can experience."

• Use our Fund Evaluator to research international bond funds.
  
• Learn about emerging market debt exchange-traded funds in our ETF Center.
  
• Find other fixed income investments that might be right for you. 
  

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Before investing, consider the fund's investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully before you invest or send money.

Investment decisions should be based on an individual's own goals, investment time horizon, and tolerance for risk.

Past performance is no guarantee of future results.

Diversification does not ensure a profit or protect against a loss.

Foreign investments, especially those in emerging markets, involve greater risk and may offer greater potential returns than U.S. investments. This risk includes political and economic uncertainties of foreign countries, as well as the risk of currency fluctuation.

1. Source: FMRCo, as measured by J.P. Morgan EMBI Global Index.

2. Emerging-Markets Fans Ignore Bond Funds to Their Detriment, Fund Spy Newsletter, by Samuel Rocco, April 7, 2009.

3. Source: FMRCo, as measured by JP Morgan EMBI Global Index and the MSCI Emerging Markets Index.

All indices are unmanaged and performance of the indices includes reinvestment of dividends and interest income, unless otherwise noted. The indices are not illustrative of any particular investment and it is not possible to invest directly in an index.

The J.P. Morgan Emerging Markets Bond Index Global is an unmanaged market capitalization-weighted index of U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by emerging markets' sovereign and quasi-sovereign entities.

The Morgan Stanley Capital International Emerging Markets Index is an unmanaged market capitalization weighted index of equity securities of companies in various countries. This index is designed to represent the performance of emerging stock markets throughout the world, excluding certain market segments unavailable to U.S.-based investors.

Barclays Capital^® (BC) 3-Month U.S. Treasury Bill Index is an unmanaged market value-weighted index of investment-grade fixed-rate public obligations of the U.S. Treasury with maturities of 3 months, excluding zero coupon strips.

The Barclays Capital U.S. Intermediate Government Bond Index is an unmanaged index composed of all bonds covered by the Barclays Capital Government Bond Index with maturities between one and 9.99 years. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The Barclays Capital Municipal Bond Index is an unmanaged market value-weighted index of investment-grade municipal bonds with maturities of one year or more.

The Citigroup G-7 Bond Index ex-U.S. tracks the performance of government bonds in developed nations that measure the total principal, interest, and returns in each market and provides a realistic measure of market performance, and includes Canada, France, Germany, Italy, Japan, and the United Kingdom.

The Barclays Capital U.S. Credit Index is a market-weighted bond index of U.S. dollar denominated investment-grade credit securities.

The Merrill Lynch U.S. High Yield Master II Constrained Index is an unmanaged market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. The Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure. Returns shown for the Merrill Lynch U.S. High Yield Master II Constrained Index for periods prior to December 31, 1996 (its inception date) are returns of the Merrill Lynch U.S. High Yield Master II Index.

The S&P 500^® Index, a market-capitalization-weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation.

The Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index (net MA tax) is an unmanaged market capitalization-weighted index of equity securities of companies domiciled in various countries. The index is designed to represent performance of developed stock markets outside the United States and Canada and excludes certain market segments unavailable to U.S. based investors. The index returns for periods after 1/1/1997 are adjusted for tax withholding rates applicable to U.S.-based mutual funds organized as Massachusetts business trusts.