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The Next Huge Emerging-Market Craze

Dan Caplinger
October 24, 2011

Investors are already quite familiar with the virtues of emerging-market stocks in red-hot growth areas over those of developed countries with sagging economies. But as stock markets around the world have seen lackluster performance, many investors are looking to emerging-market countries for an entirely different reason: to cash in on their bond markets.

Last week, ETF industry leader iShares released a new foreign fixed-income fund, the iShares Emerging Markets Local Currency Bond Fund (NYSE: LEMB  ) . Competing against the WisdomTree Emerging Markets Local Debt Fund (NYSE: ELD  ) , which started trading in 2010, the iShares ETF is just the latest example of how financial companies are trying to give investors the exposure to higher-income investments they crave.

Get outta here
Investors face two problems. On one hand, Treasury yields are near record lows, with the 10-year Treasury having fallen below 2% recently before bouncing back somewhat. The domestic situation is so bad that many investors have chosen to move into dividend-paying stocks as an income-producing alternative, even though it means taking on more overall risk in their investment portfolios. Yet for many, raising stock exposure simply isn't consistent with their risk tolerance, and so they need to look for other choices.

At the same time, the risk of a continuing drop in the value of the dollar is very real. Inflation has reared its ugly head in the past year, with the CPI having risen nearly 4%. Although the situation in Europe briefly pushed the dollar upward in a flight away from the endangered euro, any solution to sovereign debt woes on the continent would likely restore the long-term trend against the dollar. The recent S&P downgrade of U.S. debt, along with the Federal Reserve's promise to keep rates low until at least mid-2013, also weigh against the dollar's strength in the coming years.

To address those problems, emerging-market bonds look very attractive. With Brazil taking steps to fight inflation, interest rates there are much higher than in the U.S. -- and when you add the currency appreciation of the Brazilian real, total returns for U.S. investors in Brazilian bonds have been quite strong even considering the recent taxes the government there has imposed on foreign investors. Moreover, in stark contrast to previous conditions, it now appears that many emerging markets are far more economically stable than their developed-world counterparts. That explains the reason for the new ETF; the popular iShares JPMorgan USD Emerging Markets Bond ETF (NYSE: EMB  ) gave investors half of what they wanted, but didn't provide local-currency exposure to hedge against a dollar decline.

Look out below
However, those looking to emerging market bonds to save them need only look at their stock counterparts to see the dangers in the developing world. (Nasdaq: BIDU  ) , for instance, has taken investors on a roller-coaster ride, with the stock down more than a quarter from its highs just a few months ago on fears about the