Are emerging-market bond funds worth considering? What are some good funds?

QUESTION: Are emerging-market bond funds worth considering as a diversification tool? What are some good no-load choices?

-- Sunny Mahajan

ANSWER: From a pure diversification perspective, these funds may indeed be worth considering. After all, most fund investors don't already have a stash of, say, Brazilian bonds in their portfolios. But that doesn't mean this group makes sense for everyone. "If you want a little bit of foreign pop and you're an aggressive investor with a long time horizon," investing a small amount in an emerging-markets bond fund could be a reasonable thing to do, says Bill Rocco, senior analyst at fund-tracker Morningstar. Don't fit that bill? Then you probably want to seek diversification elsewhere.

Emerging-market bonds as an asset class really came on the scene only in the past 12 years or so, explains John Carlson, manager of Fidelity New Markets Income fund (FNMIX). (And many funds have shorter records than that.) The category surfaced after the U.S. began restructuring the debt of defaulted commercial banks (mostly in Latin America) using what's known as Brady bonds (named after the treasury secretary during the senior Bush administration). Even now, this fund group is still quite small, with roughly 20 funds available, according to Morningstar.

Nevertheless, this little bunch is generating some attention. Why? Well, not only are they the best performing fixed-income group over the past year, but with one-year average returns of 18.71% (and three-year annualized returns of 14.49%), they're also beating the pants of the vast majority of equity funds, too.

It's also worth noting that these bond funds have performed significantly better than emerging-market equity funds over the past one, three and five years, according to Morningstar. That's in part because the bond funds invest mostly in the bonds of the governments themselves (often in U.S. dollar denominations), while the stock funds hold corporate equities, explains Mike Conelius, manager of the T. Rowe Price Emerging Markets Bond fund (PREMX). Over the past decade, government bonds have proven to be a more lucrative bet.

So what's driving returns? A few things. For starters, government credit quality is improving, says Mohamed El-Erian, manager of the Pimco Emerging Markets Bond fund (PEBIX). (Note: This fund's snapshot is only for institutional shares -- but other share classes are available for individual investors.) And after the Asian crisis in 1998 (which caused this group to lose, on average, 23.5% that year), financial disclosure has also improved. Russia, which many of these funds invest in, has also seen a dramatic improvement after its 1998 meltdown. And rising energy prices have helped out governments of petroleum-producing nations.

But while returns as of late have been rosy, even the fund managers themselves caution that individual investors need to be careful with this group. After all, while these funds are indeed bond funds (with generous yields), their volatility makes them behave a lot more like equities. "A little bit goes a long way," says Fidelity's Carlson. "If people want to invest for five to seven years, it's a great place to put some of your money. If you're trying to time the market and be in and out in three weeks, you're liable to lose your shirt." In addition, you shouldn't allocate more than 5% of your total portfolio to this group, says Andrew Clark, senior research analyst at Lipper. A more cautious approach is to consider a global bond fund that invests a small portion of its portfolio in emerging markets.

So what are some good picks? We like the three funds highlighted in this article. Both the Fidelity and the T. Rowe Price portfolios are no-load funds with solid track records and minimum investments of $2,500. The Pimco fund also has a good track record, and its D shares don't carry a load.