Sick Of Low-Yielding Bonds? Here's A Better Way To Diversify

I'm talking about bonds.

Most investors are aware that fixed-income is a necessary part of their overall portfolio even if it does not receive the attention given to equities. Whereas investors will follow stocks and look to greater returns and diversification in their equity portfolio, they are normally content with a generic bond fund that invests in "AAA"-rated U.S. corporate debt without much management. 

But if you want to have a truly dynamic income portfolio, then you need to look in other places, too.

Enter: emerging-market bonds.

Don't be fooled. It's not as risky as you might think. In fact, these are some of the safest income vehicles you can own. 

According to research by JP Morgan, emerging-market corporate debt has seen lower default rates than U.S. corporate debt in the past five years. And thanks to exchange-traded funds (ETFs), you don't have to worry about buying these individually through your broker. You can get a basket of highly-rated, high-yielding emerging-market debt all with one click on your computer.

Here are my favorite choices in this space…

Safety and return with government bonds
The PowerShares Emerging Markets Sovereign Debt Fund (NYSE: PCY) invests in the dollar-denominated debt of about 22 emerging-market countries, the majority of which are rated investment grade by Moody's and Standard & Poor's. 

Because the fund only invests in dollar-denominated debt, you do not have to worry about volatile movements in the foreign exchange market. And here's the kicker: As a group, emerging-market countries in the fund have smaller fiscal deficits and carry much smaller public debt burdens as a percentage of GDP than their developed market peers. 

During the past year, investors in the fund have seen less volatility in shares than the SPDR Barclays Capital International Treasury Fund (NYSE: BWX), and even better, have seen their shares outperform the international fund by more than 12%. The fund has an extremely low correlation (0.46) with the S&P 500, meaning greater diversification in your overall portfolio. 

You'll also get a 5.2% dividend yield and pay an expense ratio of just 0.5%, less than the average for ETFs. The fund holds a diversified mix of regional sovereign debt with Europe, the Middle East and Africa (EMEA) representing the largest exposure (43.3%), followed closely by Latin America (34.8%) and Asia (21.9%).

Strong balance sheets and high yields with corporate bonds
The Wisdom Tree Emerging Markets Corporate Bond ETF (Nasdaq: EMCB) is the first broad-based, emerging-market corporate bond ETF. The fund maintains at least 65% of its holdings in investment-grade debt and actively seeks high-yield emerging-market corporate debt with the potential to outperform on a risk-adjusted basis. 

High yield in EM corporate bonds doesn't necessarily mean high risk. On average, emerging-market corporations use less leverage on their balance sheets than companies in developed markets. 

In the past three months, the fund has seen half the volatility of theSPDR Barclays Long-term Corporate Bond Fund (NYSE: LWC), its U.S.-focused counterpart. The fund pays a 5.0% dividend yield and charges an expense ratio of 0.6%. 

Not only do you get diversified exposure across emerging regions, but across cyclical and noncyclical sectors as well. Corporate debt in Latin America represents roughly half of the fund (50.8%) while Asia and EMEA each represent about a quarter of the holdings. 

It's a brave new world for emerging markets
The most recent crisis in Europe has shown an interesting dynamic. Whereas historically the emerging world has caught the proverbial cold when the developed market sneezed, the depth and length of this crisis has been greater in the developed world than in emerging markets. Volatility, the standard measure of risk, in both of the funds I mention above, has been below 7.0% over the past year compared with more than 23% for stocks in the S&P 500. 

Europe is now asking for help from China and Brazil! Which would you rather trust with your hard-earned money for income?

Risks to Consider: As debt denominated in dollars, a foreign currency for the issuers, the sovereign fund is exposed to the risk of extreme currency fluctuations. Extremely high and persistent inflation in one of the countries would cause their currency to depreciate, making dollar-denominated debt more expensive. This scenario played out in the Asian Crisis of 1997. The amount of foreign reserves and relatively low inflation in the emerging world should limit the likelihood of another crisis. Diversification across 22 different countries could help mitigate problems in any single country or region as well.

Action to Take--> While high-quality domestic corporate bonds will still probably fulfill the majority of your fixed-income needs, the addition of emerging-market government and corporate bonds can provide higher returns and lower portfolio risk. Depending on your risk tolerance and total portfolio allocation to bonds, you may want to invest up to 35% of your bond allocation in emerging-market funds like those listed above.

-- Joseph Hogue