In recent years, plenty of investors poured into emerging market stock funds. The new shareholders hoped to profit from the boom in developing countries, such as China and Brazil. But their high hopes were dashed by the credit crisis. During the 12 months ending in February, emerging stock funds lost, on average, 57.7 percent, their worst showing since Morningstar began tracking the category in 1990.

Clearly, the emerging funds are too volatile for many clients to stomach. But there is a steadier way to participate in fast-growing developing economies: emerging market bond funds. These rank as one of the best-performing asset classes of recent years. Over the past 10 years through April, emerging bond funds returned 9.8 percent annually, outdoing nearly every stock and bond category tracked by Morningstar. In the same period, emerging market stock funds returned 8 percent, while the Barclays Capital Aggregate Bond index returned 5.7 percent.

The Risks

Make no mistake, emerging bond funds come with risk. During 2008, the funds lost 17.6 percent. While that was painful, the emerging bonds proved relatively stable compared to such risky categories as high-yield bond and bank-loan funds, which each lost more than 26 percent. Lately, emerging bond funds have been snapping back, and they could be a sound choice for investors who want to shift some assets into the developing world. “Now is a time for investors to take on a bit more risk,” says John Sterba, president of Investment Management Advisors, a registered investment advisor in New York that clears trades through Charles Schwab Institutional. “By buying some emerging bonds, you may be able to diversify your portfolio and possibly boost returns.”

In the late 1990s, emerging bonds — which include government and corporate issues — were seen as shaky assets that suffered periodic meltdowns. But then many countries began tightening their belts, reducing government deficits and accumulating foreign currency reserves. With commodity markets booming and many countries industrializing, credit quality improved. Countries such as Russia and Mexico won investment-grade ratings. Today about half of all emerging bond assets are considered investment grade.

In the current crisis, many emerging economies have proved relatively stable, as well. Banks in Asia and Latin America did not indulge in the easy lending standards and excessive leverage that have plagued the U.S. That has enabled some countries to avoid meltdowns, despite downturns in exports. “The emerging economies were the last to be hit by the global slowdown, and they could be the first to recover,” says Matt Ryan, portfolio manager of MFS Emerging Markets Debt (MEDAX).

Most emerging bond funds hold a mix of government and corporate issues. Since few issues in the developing world are rated A or higher by Standard & Poor's, cautious investors must settle for funds that have big positions in bonds rated BBB, the lowest investment-grade rung.

Relatively Conservative

Investors seeking conservative exposure to the developing world might consider PIMCO Emerging Markets Bond (PEMDX), which focuses on government bonds. The fund emphasizes higher-quality countries, including Brazil and Russia. “We tend to avoid lower-rated credits, such as Ecuador,” says Curtis Mewbourne, co-head of PIMCO's emerging markets portfolio management team.

Lately PIMCO has been overweight Mexico. Besides holding substantial foreign currency reserves, the country has a line of credit from the International Monetary Fund that could provide support if the global recession worsens. By sticking with the most solid emerging market bonds, the fund proved relatively resilient during last year's downturn.

Another fund that outperformed in 2008 is Payden Emerging Markets Bond (PYEMX). The fund has 66 percent of assets in bonds rated BBB or higher, including a big position in Brazil. Payden can put as much as 20 percent of assets in corporate bonds. Last year, portfolio manager Kristin Ceva held risk in check, keeping 90 percent of assets in sovereign bonds and avoiding shakier issuers. But lately she has been buying some bonds rated below-investment grade, including issues from Serbia and the Dominican Republic. “For those countries, there is not as much default risk as has been priced into the market,” she says.

To limit currency risk, Ceva focuses on sovereign bonds that are denominated in dollars. But last year she earned some profits during the downturn by shorting Hungarian and Turkish currencies.

Holding a mix of corporate and government bonds, MFS Emerging Markets Debt (MEDAX) has returned 13.3 percent annually for the last 10 years, outdoing 96 percent of its competitors. While portfolio manager Matt Ryan typically emphasizes investment-grade issues, he sometimes buys unloved bonds in countries such as Venezuela, where government policies have not always favored bond holders. “Even though developments in Venezuela have not been appealing, we have positions there because you are being compensated for the risks,” Ryan says.

Worried that the world economy was weakening in 2008, Ryan began selling corporate bonds and shifting to steadier sovereign issues. At the same time, he steered away from weaker countries, such as Pakistan and Kazakhstan. “We overweighted stable investment-grade countries, such as Chile and Panama,” he says. “That helped in the downturn.”

Another fund that includes corporate and government bonds is TCW Emerging Markets Income (TGEIX). Looking for bargains, portfolio manager Luz Padilla invests in the full range of credit qualities. “Besides sovereigns we look at a variety of corporate bonds, including defaulted assets,” she says.

When Padilla likes a country, she can overweight it substantially. The fund currently has 11 percent of assets in Indonesia, more than double the country's weight in the benchmark. The Indonesian holdings include some corporate bonds that seem particularly solid because the issuers are partly owned by the government.

Investors seeking extra diversification should consider T. Rowe Price Emerging Markets Bond (PREMX). While portfolio manager Mike Conelius holds big positions in investment-grade government issues, he has 17 percent of assets in so-called frontier markets, less developed countries that include Ghana, Nigeria and Serbia.

In a contrarian move, Conelius has a big stake in Iraqi bonds. Despite the war, he figures that the oil-rich country has plenty of cash to make interest payments on its bonds. “At current oil prices, Iraq can pay its annual interest burden with just a few days of export revenues,” he says.