Investors seeking income can find it in emerging-market bonds

A conundrum for investors during the last decade has been how to generate income in a world with little or none of it to speak of. In hindsight, they could have owned just about any asset, watched its value soar and sold bits of it along the way, but that was not a viable option for those among us who must start each day in ignorance of what will unfold.

With bond and stock yields still hovering not far from zero percent due to extravagant valuations and the extravagant central bank monetary policies that enable them, few attractive income sources exist. One that was floated recently in research by RBC Global Asset Management is emerging market debt.

It’s easy to see why that niche of the bond market would capture the firm’s attention. In the first nine months of this year, the average mutual fund that invests in emerging market bonds denominated in U.S. dollars or other hard currencies rose 13.5%, according to investment researcher Morningstar, and local-currency bond funds did even better, with an average gain of 15.8%.

Most of those returns are from capital appreciation, but the income paid by the bonds is substantial, compared to just about any other asset. RBC notes that the average yield recently was 5.1% on emerging market dollar-denominated government debt, and 6.2% on local-currency government instruments.

RBC cited four factors to account for the strong overall returns this year: reduced expectations of rate hikes by the Federal Reserve; a “stabilization of expectations surrounding China,” driven by some success in improving economic growth and stemming a capital outflow that put pressure on the value of the Chinese currency, the renminbi, against the U.S. dollar DXY, +0.17; a solidification of political institutions in the developing world that could provide momentum for economic reform; and improving balance sheets among businesses in emerging economies, aided by such developments as the rebound in commodity prices.

Things are getting better because they’re not getting worse.

In other words, things are getting better because they’re not getting worse, and with valuations on emerging market debt reasonable to begin with, that has been enough to boost prices substantially.

But the report also highlighted the fact that there are markets and then there are markets. Looking at returns in the first half of the year, Brazil had the best among major countries, up 21%, while Hungary was last, up 4%. Brazil was also tops in local-currency performance, rising 47%, compared to a 2% decline for Mexico.

RBC anticipates a continuation of both trends — good, if spotty, results: The firm reports: “The positive return environment is likely to continue this year, while differentiation will remain critical to maximizing performance. . . . Stabilization of [emerging market] fundamentals will lead to significant reengagement from . . . investors facing a low-yield world. Neither hard-currency nor local-currency yields look particularly stretched on a historical basis, reinforcing the prospects for further tightening” of yield premiums over those of safer instruments like U.S. Treasury bonds.

The variability of returns and the exotic, niche character could make emerging debt markets one of the few asset classes for which investors stand a decent chance to improve their results by going with actively managed funds. While Morningstar recorded a very thin superiority of returns for passively managed ETFs, the variability of returns among actively managed mutual funds was stark. The best of the hard-currency portfolios gained close to or better than 20 percent in the first nine months, while the worst were in the middle single digits.

Whichever fund you might choose, if any, bear in mind that the comparatively reasonable prices of emerging market bonds will not inoculate them against a decline should the overvaluation in mainstream assets catch up with them at last. After all, if you arrive late to a party, you can’t expect it to keep going once the other guests have gone home. At a party or in an investment, therefore, take care whose company you’re keeping in case the fun stops.