Need proof that the mighty can fall? Then consider the earthquake that shook emerging markets with the government of Dubai’s Nov. 25, 2009, announcement that it would seek to restructure the liabilities of its holding company, Dubai World.

The whiff of default raised the question of Dubai’s ability to service its sovereign debt, which is US$59 billion, according to credit-rating agencies. In the tightly connected global debt market, what happens in Dubai is felt around the world. As a result, those investors who had hoped to reap gains from the global debt market’s recovery rediscovered emerging-markets credit risk.

Credit-rating agencies that had given high ratings to Dubai’s sovereign and sovereign-guaranteed debt promptly downgraded the emirate’s debt. New York-based Moody’s Investors Service Inc. lowered the rating of marine terminal operator DP World, another government of Dubai company, to Baa2 from A3 — to “so-so investment-grade” from almost “top drawer” — as well as dropping other units of Dubai’s government-held operations in similar fashion.

The looming debacle, which may yet be averted if neighbouring emirates, such as Abu Dhabi, bail out Dubai, appeared just five days after the JPMorgan Chase & Co.emerging markets bond index, the EMBI+, jumped to 495 in early December, 30% higher than its level of 380 in March. The soaring value of the EMBI+ was reflecting the comfortable credit conditions in developing economies, particularly the BRIC countries — Brazil, Russia, India and China — that were expected to post strong gross domestic product growth of 5.1% in 2010, according to the International Monetary Fund, compared with 1.3% for the more advanced regions.

Into this bullish market have come unlikely candidates for the developed world’s money. For instance, Angola has appointed JPMorgan to lead a US$4-billion bond issue. A former bond defaulter, Angola has no credit rating at present, notes JPMorgan. Yet, according to bond traders, the Angola issue, which is likely to be denominated in U.S. dollars, will be sold. If there are differing opinions on the likelihood of a default — and what amounts may be recovered, if that were to happen — valuations will vary and a market can develop.

Indeed, sovereign junk, which is the hardest debt on which to collect, is prime for trading. So, it’s no wonder that emerging-markets bonds are getting respect.

Some former defaulters, such as Brazil, have what is now seen as senior debt among the emerging markets. Brazilian short-term rates are currently 8%-8.5%. But, for the record, Brazilian banking institutions and regional governments had 16 bond defaults in the period from 1995 to 2008. The leader in defaults, by value, remains Argentina, with its US$70-billion sovereign default in 2001-02. The leader in sheer quantity of defaulted issues is Indonesia, with 63 defaults in the 1995-2008 period.

In analyzing 431 emerging-markets defaults, a recent Moody’s report noted, not surprising, that these defaults are concentrated in periods of global economic crises, such as the 1998 Thai baht collapse, the 1999 Russian ruble default and the 2002 Brazilian economic collapse. It is a worrisome history for those investors who want to buy-and-hold rather than trade.

“Emerging-markets bonds present not only credit issues but currency issues, too,” says Caroline Nalbantoglu, a registered financial planner with PWL Advisors Inc. in Montreal. “My clients buy bonds to add security to their portfolios. Emerging-markets bonds are intrinsically more speculative than Canadian bonds, so I could not recommend them.”

Nevertheless, there are rewards to be had for taking on emerging-markets bond risk. Brazil’s current interest rates, administered by its central bank, are in a low band, at least for Brazil, of less than 9%; Russian short rates are 9%; China’s, 5.1%; and India’s, 7.1%.

In terms of currency risk, the Brazilian real is up by 15% year-to-date against the loonie, while the Indian rupee is sagging. The Chinese yuan, widely regarded as being undervalued, and the Russian ruble are pegged to the US$ and their values are politically determined. There is risk, of course, that either country could lower the peg.

For now, emerging-markets bonds offer good returns with reasonable risk, suggests Tristan Sones, vice president and portfolio manager with AGF Management Ltd. in Toronto: “Credit across the board was weak last year. But now, credit spreads in everything from investment-grade corporate bonds in the G7 to spreads on sovereign debt in emerging markets have narrowed. Going forward, there should be good gains in emerging markets such as Brazil.”

Other good debt issues include those from Turkey, Poland, Panama, Mexico and South Africa, says Fergus McCormick, senior vice president for sovereign ratings in New York with Toronto-based credit-rating agency DBRS Ltd.

Direct purchase of emerging-markets bond issues is difficult for retail clients, as these issues tend to be bought up by institutions. As well, given that many issues are smallish on the U.S. bond-market scale — in which just a few billion dollars doesn’t really rate as liquid — they are difficult to buy and sell. It’s easier to buy into investment funds.

Global fixed-income funds managed in Canada blend debt from Mexico, Argentina, Poland and the BRIC countries into their portfolios, but none is a pure emerging-markets debt play. Most sector funds — other than bank-issued global bond index funds, light in emerging-markets bonds, and a few life insurance company bond portfolios — did well in the 12 months ended Oct. 31, 2009, with average gains of 9.1%.

Among the Canadian dollar-denominated funds, Mackenzie Sentinel Global Bond Fund led with its 14% return for the same 12-month period, net of its 2.07% management expense ratio. It should be noted, however, that the DEX corporate bond index was up by 14.8% in the period. In other words, one could have had a good return equal to the Mackenzie fund’s gain without the currency and higher than average default risks.

As well, there are two emerging-markets bond exchange-traded funds, traded on the New York Stock Exchange in US$: JPMorgan Emerging Markets Bond Fund and PowerShares Emerging Sovereign Debt Fund are cost-efficient ways to participate. As of early December, both ETFs are up by about 30% over their March lows but down by about 10% from their peaks this past October.

So, should you recommend that clients put fresh money into emerging-markets debt? Says Vivek Verma, vice president of Richmond Hill, Ont.-based bond management firm Canso Investment Counsel Ltd.: “You have to look at emerging markets separately and look at their reserves. Brazil, India, Russia and China have huge reserves. But past defaults — such as Russia’s, when oil prices declined in 1998 and 1999 — show the risks.” IE