The attraction of emerging market bonds

In one hugely significant respect, emerging nations surpass their western counterparts: in the quality of their debt.

While we in the West have spent like drunken sailors who won the lottery and have long forgotten where their ships are, developing markets have quietly established strong balance sheets.

Their debt to GDP ratio is about 40% compared with more than 100% in many developed countries.

This new world order is enticing investors on an unprecedented scale. So far this year emerging market corporate and sovereign bonds have been issued at a record pace.

Borrowers, including governments and companies, have raised almost $300 billion to date - a 10% increase on the same period in 2009, which was itself a record year, according to data from Thomson Reuters.

The rationale behind this wave of investment tells the same story as the enthusiasm for dividend income from developing markets.

The old world order is changing. While a number of western countries - Greece is just one among many - have large budget deficits, huge indebtedness and poor growth prospects, emerging market countries have, in the main, strong economies, manageable budget deficits, current account surpluses and good growth forecasts.

In addition to bonds issued by companies, there are two main types of emerging market sovereign debt: hard currency bonds denominated in US dollars, and local currency bonds. The latter dominate the market, but are more risky, although potentially more rewarding.

The risks are those usually associated with debt issues, namely fluctuations in the issuer's economic or financial fortunes, and the ability to meet payment obligations.

However, with emerging economies, the risks are heightened by potential economic and political volatility. These factors are less worrying than in the past, but investors must bear them in mind when assessing the attraction of emerging market bonds.

And in the case of local currency bonds there is also the potential for ups and downs in the currencies in which they are denominated.

That said, these are tempting investments. The jpmorgan government bond index-emerging markets (gbi-em) is composed of bonds of around a four-year duration that yield around 7.2%.

This article was originally published in Money Observer - Moneywise's sister publication - in August 2010