The Anti-Eurozone Debt Solution

Investors who breathed a sigh of relief as this past spring's debt crisis in Greece seemed to fade away without incident may have slipped into complacency a bit too soon. Worry over the state of indebtedness in several eurozone nations has erupted once again, knocking worldwide markets for a loop. And as European banking officials and governmental agencies rush to calm jittery investors, many are wondering if any assistance will be too little, too late.

Seeking a lifeline
While Greece may have played a major role in the debt scare earlier this year, this time around Ireland is taking center stage. Markets are placing tremendous pressure on the debt-laden nation, increasing the cost of ensuring sovereign debt against default and driving up yields on Irish bonds. Even more troubling, last week Moody's downgraded Ireland's debt to just three steps above junk status.

Along with Ireland's overall downgrade, Moody's also downgraded several large Irish banks, including Allied Irish Banks (NYSE: AIB  ) and Bank of Ireland (NYSE: IRE  ) , both of which have lost roughly two-thirds of their value this year alone. The EU and International Monetary Fund have extended Ireland a rescue package, without which it might have faced the likely prospect of insolvency. Of course, the bigger problem here is that a potential default in Ireland could ripple across Europe, bringing down other countries struggling with a crushing debt load, including Portugal, Greece, Spain, and perhaps even Italy.

While long-term stock and bond investors shouldn't flee the eurozone entirely, the area's fiscal concerns are not likely to be resolved any time soon, even with the assistance of a bailout. That means investors may want to direct new investment contributions to other areas around the globe that have better near-term prospects. Investors in search of yield are already finding a new home for their foreign debt dollars -- emerging market bonds.

According to data provider EPFR Global, more than $50 billion made its way into emerging bond funds through mid-November of this year, a record amount. Since the risk of default appears to be much lower in developing nations that don't have such crippling debt loads, skittish global investors are likely to find this area especially attractive. And for folks who want exposure to currencies beyond the weakened dollar and euro, emerging bonds offer a built-in currency play.

A bumpy ride
While many investors should be able to find a place for emerging market debt in their portfolio, it's important to keep in mind that this asset class is very volatile. You shouldn't think of emerging market bonds in the same way you do U.S. Treasuries or even developed market debt. Investors should view emerging market debt as a diversification and capital appreciation tool, rather than a capital protection device. So don't allocate money to this sector that you can't lose or need to generate income from for living expenses. The average emerging market bond fund lost nearly 18% in 2008, so you need to be prepared for potential losses of this magnitude down the road.

Investors should also keep in mind that while emerging markets may be financially healthier than many debt-laden developed nations, they won't escape from the eurozone financial crisis completely unscathed. If the situation worsens, the contagion may spread across the globe, hitting emerging nations as well. Not to mention that emerging markets have been pretty popular in recent years, seeing billions of dollars in inflows. Emerging market debt is definitely not as cheap as it once was, and may even be showing some initial signs of becoming overextended, so keep your expectations in check here and be prepared to invest for the long run.

Taking the plunge
If you're going to make the foray into emerging debt, be sure to keep your allocations small, especially for investors closer to retirement. One good, diversified fund choice in this space is Fidelity New Markets Income (FUND: FNMIX  ) . Unlike many Fidelity funds, which feature a veritable merry-go-round of managers, this fund's manager has been with the fund for more than 15 years. John Carlson employs a measured approach to investing in this volatile sector, keeping risks in line and a focus on diversification. Costs are reasonable here, and the fund ranks in the top 15% of its peer group over the past decade and a half.

Exchange-traded fund fans can also get in on the action in this sector. There are a few emerging market bond ETFs available, including Wisdom Tree Emerging Markets Local Debt (NYSE: ELD  ) , PowerShares Emerging Markets Sovereign Debt (NYSE: PCY  ) , and Market Vectors EM Local Currency Bond ETF (NYSE: EMLC  ) . These funds have annual expense ratios ranging from 0.49% to 0.55%, offering low-cost access to the emerging market debt arena. Just keep in mind that risks here are the same as with an actively managed fund of the same stripes.

While emerging markets are likely to face their own pressures and difficulties in the near future, they remain a viable option for investors leery of the future of eurozone finances. Risks will be high here, but for patient investors, rewards may just as meaningful.

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Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Try any of our Foolish newsletter services free for 30 days.

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  • Report this Comment On December 21, 2010, at 4:14 AM, bourse wrote:

    Great article! It is exactly this shift of bond investors away from Eurozone bonds which is underway even in these "low volume days" before year end.

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