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Adventures In Fixed Income

Emerging markets bonds, junk bonds, and strategic bond funds are the top choices as European pension funds move into riskier types of fixed income.

It’s been well documented that institutional investors, made wary by the market turmoil, have been shifting out of equities into bonds. But now, apparently itchy for the higher returns of equities, European pension funds are seeking a middle ground via riskier types of fixed income. And, as a new report from Cerulli Associates puts it, “the growing appetite for fixed-income instruments has been matched by a plethora of new products” from vendors such as Invesco and Scottish Widows Investment Partnership.

The most popular, according to the third-quarter 2010 European edition of The Cerulli Edge, include emerging markets bonds, junk bonds, and strategic bond funds, which try to adjust their risk profile to market trends and interest rates.

Investors are especially looking at sovereign debt from Brazil, Mexico, and Indonesia, Barbara Wall, Cerulli’s editor of global and European research, said in an email interview. Notably, large and midsize pension funds are flocking to bonds denominated in local currencies, although smaller funds are still sticking with traditional hard-currency investments. Even “increased exposure to corporates is being talked about,” Wall said.

The result: Global emerging markets bond funds gained some $17 billion in net new assets in the first six months of this year, compared with $14 billion for the prior six months. More than half of the inflow, furthermore, went to local-currency paper. As for junk bonds, Cerulli says, “Last year was the first since 1996 when every month saw consistently positive flows.”

Some typical three-year returns (for the period that ended in late January) cited in the report include 76 percent for the Investec Emerging Markets Debt fund, 41 percent for the Threadneedle Emerging Market Bond, and 38 percent for the M&G Emerging Markets Bond fund.

Returns, and even diversity, aren’t the only reasons for these investments’ newfound popularity. For one thing, there just hasn’t been enough classic, high-grade debt, because market volatility has scared off corporate issuers. And ever since the virtual collapse of the Greek economy earlier this year, euro-backed paper hasn’t looked so tempting. In a way, too, the interest in emerging-market debt parallels a growing interest among U.S. pension funds in emerging-markets equities.

Of course, we all know that returns don’t come without risk, especially in relatively small, untested arenas. In particular, investors are nervous about inflation in Russia and about the high issuance that their own appetite has spurred. “There is a sense that perhaps the markets have gotten ahead of themselves,” Wall concedes. And the report warns that when it comes to the strategic funds, which have been marketed for only about seven years, “The risk is that the fund manager takes big asset allocation bets and gets it wrong, which is why investors have to focus on the long term – three year – performance figures of the funds.”

Still, Wall concludes, for these new fixed-income vehicles overall, “The general sentiment seems to be that the risks are much less than in previous cycles.”

Fran Hawthorne is the author of the award-winning “Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street” (Bloomberg Press) and “Inside the FDA: The Business and Politics behind the Drugs We Take and the Food We Eat” (John Wiley & Sons). She writes regularly about finance, health care, and business ethics.

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