Emerging-market bonds have come into the limelight. Investors who used to disdain debt from countries with histories of default and traditions of high inflation have driven up the prices of government bonds from countries such as Brazil, Argentina, India, Russia and some in eastern Europe.

For instance, Newport Beach, Calif.-based Pacific Investment Management Co. LLP’s Developing Local Markets Fund returned 17.2% for the 12 months ended Sept. 30. A leader in what today appears to be the most bulletproof bond sector, the PIMCO fund’s gains show how sentiment has changed to favour the bonds many used to hate.

With no subprime housing loans to cripple bank earnings and no asset-backed derivatives hanging over credit markets, emerging markets are being seen as solid and dependable. It is a curious turn of fate.

By contrast, U.S. bonds have done poorly in Canadian dollar terms. According to Salomon Brothers index data, U.S. corporate bonds returned 7.3% for the 12 months ended Sept. 30, then lost 4.1% in C$ terms in the same period as the high-flying loonie devastated gains in greenbacks.

In the turbulent August market, says Chris Kresic, senior vice president at Mackenzie Financial Corp. in Toronto, emerging-market bond prices moved down about one standard deviation while Canadian bank bonds moved down as much as four standard deviations. In the days following the Aug. 16 meltdown, emerging-market bonds followed stock markets to regain their value, while Canadian bank bonds and asset-backed commercial paper failed to bounce back.

The behaviour of emerging-market bonds, which usually trade in tandem with high-yield debt, has changed. Investors seem to be saying there is less risk in buying Polish zloty bonds or Brazilian real bonds than in taking on Canadian corporate debt — especially financial services debt.

“The view in mid-August was the debt crisis had produced systemic risk that would affect everything,” Kresic says. “Now, the market has said the risk is not systemic, but specific to subprimes and structured debt.”

There is more at work in the hot returns of emerging-market bonds. Their underlying currencies are also strong. Richard Gluck, a principal at Trilogy Global Advisors LLC in New York who runs US$800 million of global bonds, notes the Turkish lira is up 18.7% year-to-date and the Brazilian real is up 18.6%. They have paced this year’s 19% rise in the loonie.

Government bonds issued in lira and real have thrived as Turkey has produced a 6.8% rise in gross domestic product for the first quarter of 2007, and Brazil has produced a 4.3% rise in its GDP in the same period. In comparison, the U.S.’s GDP was up 1.9% in the second quarter of 2007 from second quarter 2006, and Canada’s GDP was up 2.5% in the same period, according to British newsweekly the Economist.

With the C$ continuing to gore otherwise strong returns of U.S. and other foreign bonds, it is especially important to evaluate not only the relative return and risk of a bond, but also the underlying macroeconomic environment of the issuer and the prospects for the currency in which the bond was issued, and then to compare all of that to the loonie outlook.

“In this new world of bond values, the U.S. has tumbled from its perch. U.S. treasury bonds are not attractive from a total return perspective,” Gluck says. Indeed, with the prospect of further short-term gains of the loonie against the greenback, U.S. T-bonds could produce losses in C$ terms for some time to come.

For the coming year, the best plays in global bonds will be in emerging-market debt from countries that sell products tied to global growth, Gluck says. These export-driven winners include Canada and Australia for resources; New Zealand, a major food exporter; Brazil, a source of iron ore; and Chile, a major copper exporter.

It will take sensitivity to both currencies and interest rates to play global bonds for the year ahead. Says Nick Chamie, head of emerging markets research at RBC Capital Markets in Toronto: “We are positive on Brazil, Turkey and Russia. We think five-year Turkish lira bonds due Sept. 14, 2012, with a 14% coupon that pay 15.5% to maturity are a good bet. We also like Brazilian interest rate futures, which trade like bonds, that are yielding 11.2%. On Russia, we like the implied yield in foreign exchange forward of 6% plus the expectation of a rise of 4% of the ruble against the greenback, for a total return of 10%.”

@page_break@WORK WELL WITH C$

Global bond funds have varying exposure to emerging markets. For a client who wants to make market-specific purchases of global bonds, special care is in order. “We are cautious about Argentina,” Chamie adds, “which will have a new government when Cristina Fernández de Kirchner, wife of current president Néstor Kirchner, takes over. There is an upside chance she could produce positive surprises that would lift the market.”

Emerging-market bonds that work well when the C$ is rising should do even better if the C$ falters. But that leaves the largest unknown unresolved: if the US$ rose against the loonie, it could put U.S. bond funds back in the limelight.

As Gluck notes: “The C$ will not be the top-performing currency in the world forever.”

What’s ahead for the flagging US$?

“We see the US$ being weak to the end of 2007, then slowly regaining some stature,” says David Watt, senior currency strategist at RBC Capital Markets in Toronto. “We are looking at the loonie being worth US93¢-US95¢ by the end of 2008. A lot depends on the price of oil and other resources and the global economy. If the global economy cools, some of the bullish sentiment supporting the C$ will decline.”

Emerging-market bonds appear, for now, to be immune to the exchange rate uncertainties affecting the relationship of the loonie and the greenback. Supported by a strong global economy and uninvolved in the liquidity problems crippling debt markets in Canada and the U.S., top emerging-market nations are seeing their currencies gain value against senior currencies and their credit ratings improve. And as long as the global economy flourishes, prospects are good that emerging-market bonds will stay in their sweet spot. IE