Emerging market bonds are an attractive way to get a higher yield, but historically they have come with higher volatility and a high incidence of default. Most investors experience emerging market bonds as part of a bond fund that is diversified across several different countries. These include Russia, Brazil, Mexico, Turkey, South Korea, Indonesia, Colombia and the Philippines, among others.

There are many emerging market bond funds. Some are mutual funds that buy and sell constantly. Others are exchange-traded funds (ETFs) that simply buy and hold a portfolio of stocks.

Unlike stock funds, excellent bond funds often have a higher turnover ratio. When stock funds have a high turnover ratio, the added costs often drag down returns. But bonds have a higher spread when they are bought and sold. Every time a bond fund turns over, the fund sells its portfolio holdings for a profit and buys substitute bonds at a discount. The difference of the spread means profit for the shareholders.

Consider the PIMCO Emerging Markets Bond Fund (PEMDX/PEBIX) as an illustration. PEMDX or PEBIX has a turnover rate of 100%.

The two different ticker symbols represent two different share classes. PEMDX is the over-the-counter version. It has a gross expense ratio of 1.25%. PEBIX represents the institutional shares and has a lower expense ratio of 0.83%. The institutional shares are available for large investment amounts or when aggregated with a qualified financial advisor. The 0.42% lower expense ratio obviously matters to the returns that are experienced.

The 12-month yield of PEMDX is 4.31%; PEBIX is 4.72%. PEMDX returned 6.28% in 2011, 12.59% in 2010 and 30.02% in 2009. PEBIX returned 6.73% in 2011, 13.06% in 2010 and 30.54% in 2009.

Emerging market bonds are not without risks. All bond funds have interest rate risk. Most emerging market bond funds have bonds with relatively longer term holdings. And longer term bonds have more interest rate risks.

The length of bonds in a fund is measured in two ways. Maturity represents the average time until a bond completes repayment of principal. The maturity of PEMDX is 9.68 years. A second more important measurement is duration. The duration of a bond fund represents the weighted average of each payment of interest or principal. The higher the interest payments, the more they lower the average duration. The duration of PEMDX is 5.33 years.

If there is a 1% rise in interest rates, a bond fund with a duration of 5.33 years will drop approximately 5.33%. Those investing in emerging market bonds hope that the interest rate risk will be offset by the higher yield. If interest rates rise slowly, it will barely affect the annual yield.

Foreign bond funds also have currency risk. They can either hedge the currency risk or be unhedged. A hedged fund buys options in case the dollar strengthens. Buying these options costs money that reduces returns if the dollar weakens. We generally invest in unhedged foreign bond funds such as PEMDX. This purposefully exposes us to currency risk.

So if the dollar weakens, we get an extra boost of return in terms of U.S. dollars. But if the dollar strengthens, the price of the bond fund will drop accordingly. At times the dollar strengthens, but we are assuming a weaker dollar going forward as a longer term trend.

Because of the European sovereign debt crisis, the European Union will be taking monetary easing policies. So the euro will probably be devalued gradually over the next decade. U.S. debt issues mean the U.S. dollar will probably have similar troubles. Perhaps the two best reasons to invest in emerging market bonds are because they are not denominated in euros or dollars.

The third risk is default risk. With sovereign debt a global crisis, you might imagine that emerging market debt would be among the riskiest. Developed market countries are averaging a 100% debt to gross domestic product (GDP) ratio while the debt to GDP ratio in the emerging markets has been dropping as their economic activity has grown. Currently, debt is only about 40% of what they produce.

That doesn’t mean that emerging market countries never default. In fact, countries are notorious for their defaults, including emerging market countries. But it does mean that their fundamental credit quality has improved along with their economies.

Over the past decade, emerging markets have become more stable as developed markets have become more volatile. The Barclays US Emerging Market Bond Index had a standard deviation of 20.04% between its inception in 1993 and six years later in 1999. But between 2000 and 2010, its standard deviation was only 12.63%.

A lower standard deviation means a higher Sharpe ratio, which justifies a higher allocation. Higher doesn’t mean most of your bonds. We recommend putting about 25% of your foreign bond allocation in emerging market bonds. Assuming that you split your bonds evenly between U.S. and foreign bonds, this would be just 12.5% of your total bond allocation.

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