Chapter 14. Emerging Market Bonds

During the 2000–2002 bear market for equities, emerging market bonds proved to be one of the top-performing asset classes. Although the global equities markets—including emerging market equities—suffered, many emerging market bond funds delivered double-digit returns, a trend that continued from 2003 through 2006. This led to a rush of investment dollars chasing the latest "hot" asset class.

Today, the question for prudent investors is whether emerging market bonds are an appropriate building block for a globally diversified portfolio. Or are investors experiencing just another case of "recency"—the tendency to assign too much importance to recent experience, while ignoring the lessons of long-term historical evidence? Let's examine the issues to consider to make the wisest decision.

Risks

Investing in international bonds exposes the investor to a mixture of risks that are different for each country. A country's unique set of risks (for example, political, economic, and cultural) make up what is collectively called its sovereign risk, the risk of a country defaulting on its debt. U.S. Treasury bonds entail no risk of default for U.S. investors. Default risk, however, is a real threat in emerging markets. Countries have defaulted on "foreign-denominated" debt, because of their inability to generate sufficient foreign currency to repay their obligations.

Because of these inherent risks, emerging market debt is a risky asset class, characterized by extreme ...

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