As investors continue to shovel mountains of cash into U.S. Treasuries and U.S. bonds, investors seeking yield and price outperformance are advised to look at bonds issued by the emerging markets nations.

Since early April (in tandem with revelations of Greece’s debt crisis) bond yields in the U.S. have steadily fallen – the yield on the benchmark 10-Year Treasury has plunged from about 3.99 percent on April 5 to 2.82 percent as of yesterday’s close (although the yield has been rising since hitting a low of 2.38 percent in early October).

Falling bond yields continue to reflect a disdain (perhaps even fear) of stocks, despite the fact that the economy appears to be stabilizing and equities have delivered gains so far this year (and have rallied superbly from March 2009 lows).

Indeed, year-to-date through the end of September, almost $30-billion have flowed out of U.S. equity funds, while taxable bond funds have been enriched by $213-billion, according to the most recent data from the Investment Company Institute (ICI).

Milton Ezrati, senior economist and market strategist at Lord Abbett, pointed out that with the 10-year Treasury yielding below 3 percent, that barely compensates holders for inflation after taking their tax liabilities into consideration.

“U.S. bonds are definitely at or near a bubble,” said Rob Russell, president of Russell & Co. in Dayton, Ohio.

“And that bubble will pop as soon as we see any signs of inflation and the Fed is forced to hike interest rates. That action will destroy bond values, especially for those securities with intermediate to long-term maturities.”

Russell recommends that investors re-allocate some of their assets to emerging market sovereign bonds, which he believes, are poised for further growth.

Bond yields across the emerging markets currently average about 6 percent.

“That is where the value is right now, in the developing world,” he noted. “The risks are that they’re not as safe as U.S. bonds and their credit quality is not quite as good -- but that’s why you get much higher yields.”

Ezrati noted that while “investors clearly have remained fearful of equities, they have nonetheless shown little fear of the once-risky world of emerging sovereign debt.”

In fact, net flows into emerging market bond funds have amounted to nearly $40-billion through the first nine months of the year, according to EPFR Global.

As money has poured into emerging markets bonds, Ezrati indicates, these purchases “have, in fact, driven up the prices in this area even faster than the prices on U.S. Treasury and agency debt, so that yield spreads over U.S. Treasuries, according to the JPMorgan Emerging Market Bond Index (EMBI+), have collapsed by more than 500 basis points so far this year.”

While Russell concedes that prices of emerging markets bonds have indeed risen this year, they still make a good buy because they much room to further appreciate.

“Because of the inverse relationship of interest rates and bond prices, it’s the worst time to buy U.S. bonds and a much better time to buy emerging markets bonds,” he said.

“You want to buy low, not high. With interest rates and inflation heating up in placed like India, China and certain other emerging markets, that’s where you want to buy a basket of bonds, preferably thru mutual funds or ETFs. The high interest rates in the emerging markets makes bond more attractive because bond prices are attractively low. In contrast, with rates near zero in the U.S., bonds here are too highly priced.”

Russell cites, for example, that with GDP numbers coming in well ahead of expectations in India, the Reserve Bank of India will surely raise interest rates again to tamp down on overheating, further pushing up Indian bond yields.

Moreover, the composition and character of emerging market debt has drastically changed over the past ten to fifteen years (i.e., since the days when default and currency crises seemed to hit the developing world practically every year).

“These markets show much greater stability, much greater market flexibility, much less inflation risk, and much more prudent monetary and fiscal policies,” Ezrati explained.

“Credit ratings on these issues have consistently risen, so much so, in fact, that the composition of the popular EMBI+ Index has gone from 20 percent investment grade 10 years ago to 60 percent today.”
Ezrati cited that Mexican sovereign debt issues attained investment grade status in 2002, followed by Russia in 2005, and Brazilian in 2008.

“None of these ratings was in jeopardy of downgrading even during the 2008–09 financial crisis,” he commented.

Thus, while emerging markets bond remains riskier and of lower credit quality than U.S. Treasuries, the disparities between the two asset classes have lessened considerably.

The greatest risk with investing in emerging markets bond lies with the higher risk of default. Russell concedes this point, but he adds that the risk of default in any of these developing nations is lower now than it has ever been.

Indeed, many emerging nations have healthy public finances with low debt and have developed responsible, independent central banks committed to solid fiscal policies.

In stark contrast, the creditworthiness and economic stability of the debt-ridden developed nations, particularly in Europe with their ongoing woes, are now under serious scrutiny.

Some in fact believe that the likelihood of debt default is higher in nations like Ireland, Spain and Greece rather than in most emerging market countries.

Aggregate debt-to-GDP in the emerging markets is about 40 percent, versus nearly (or in excess of) 100 percent in many developed countries.

Russell suggests that investors be selective about buying emerging markets debt issues and to not concentrate too heavily in any one country or geographical region.

“Keeping a diversified portfolio with an emphasis on the higher credit quality issues is the key,” he said.