As the world evolves, so, too, does the landscape for income investors.
Emerging markets -- any country in the process of rapid growth and industrialization -- were once the exotic purview of Wall Street's high-risk trading desks.
Today, however, these nations comprise more than 40% of the world's population. They're responsible for a nearly a third of the world's gross output. And they've become a mainstream asset class that serious income investors can't ignore. (In fact, investing in emerging markets over developed markets is "Rule 6" of our proven Daily Paycheck strategy.)
The International Monetary Fund says emerging markets accounted for nearly all of the world's growth this year. What's more, they're forecasted to grow at nearly three times the pace of the rest of the world in 2010.
Several factors make this an excellent time for emerging markets:
The first is the financial posture of the Western governments post-crisis. They are continuing to rack up enormous amounts of debt to stimulate economies devastated by the recession. At the same time, these governments are also holding interest rates at rock bottom to spur investment and job creation..
Secondly, though the United States and European Union were devastated by the recession, many emerging-market countries were not exposed to the excess leverage and subprime contagion that nearly derailed the financial system. Developed countries struggled to borrow more to combat the slowdown, but emerging markets like China were able to confront it with cash surpluses.
Third, the supercharged economic growth of the past decade has improved fundamentals in many emerging markets. In 1998, only 10% of emerging-market debt was highly rated "investment grade." Today, that number has grown to about 50%, according to one Morningstar analyst. Yet interest rates in these countries are still much higher, reflecting the credit risk of years past rather than the relative strength many of the economies show today.
What these factors mean is this: Developed countries offer deteriorating creditworthiness and low interest rates; emerging markets offer improving credit strength and pay higher interest rates. This may seem backward, and it is. In the meantime, however, income investors should consider locking in emerging markets' low-risk, high-rate returns.
Funds are the best way to invest in emerging market debt. With funds, you own a share of a diversified pool of bonds that would be impossible to amass yourself. A fund can also do things you can't do yourself like employing a team of experts with resources to scour the markets from India to Argentina in search of the best investments.
These funds have been phenomenal performers. According to the J.P. Morgan Emerging Market Bond Index, emerging-market bonds have averaged about +11% per year in total return during the past 10 years -- a period during which the S&P 500 Index posted a loss. Although emerging-market bonds can be volatile, they've only experienced three down years since 1994.
One standout is the Templeton Emerging Markets Income Fund (NYSE: TEI). This fund has blown away the competition, averaging an astronomical +15% per year in total return for the past 10 years. TEI has rocketed an amazing +70% so far this year as investors have fled low-yield U.S. Tresuries in favor of higher-paying emerging-market debt. Since TEI's inception in 1993, the fund has posted double-digit positive returns in all but five years.
TEI pays quarterly dividends at $0.25 per share plus a capital gains distribution in December. At today's price, the fund yields a solid 8%. Even more impressive, TEI doesn't use leverage to juice returns. And, the quarterly dividends are all interest income.
The fund held 93 sovereign and corporate bond from all over the world with an average rating of "BBB-" from Standard and Poor's. About 55% of the fund is in Asia and Latin America and 23% is in Eastern Europe (mainly Russia). The top county weightings are Brazil and Indonesia.
The world is changing. Income investors need to change with it. It's time for income investors to embrace emerging markets. TEI has pulled back from its highs and can be bought at its current price.