Ray of light in emerging markets Private investors who were attracted by the strong yields and apparently lower risk profile of emerging market bond funds have seen the value of their investments fall over the past 12 months - highlighting the volatility still affecting debt as an asset class. But many advisers believe the longer term outlook for emerging market debt is positive. In recent years, inflows to emerging market bond funds from retail investors have increased, as their underlying investments were viewed as a safer option than bonds issued by debt-burdened governments in the developed world. Income-seeking investors were offered yields of between 5 to 6 per cent by several funds. However, as worries over the state of the global economy intensified last summer, a broad sell-off of bonds began - and investors found that emerging market bonds could be as volatile as other fixed-interest securities. According to Damien Fahy, head of research at advisers Dennehy Weller & Co, prices of dollar-denominated emerging market bonds fell 6.17 per cent in the 12 months to end of June, while those issued in local currencies were down 5.22 per cent. "It doesn't take a lot of analysis to observe that emerging market debt, whether local or US-dollar denominated, remains more aligned with riskier investments than safe havens," he notes. "This is despite their [issuers] having somewhat less debt than the US and the UK - and despite very attractive yields relative to inflation," says Fahy. Returns from emerging market bond funds also depend heavily on the type of debt they invest in: local currency debt or dollar-denominated debt. "Local currency debt has been very similar to global equities in terms of performance, while "hard-currency" US dollar-denominated debt has benefited from appreciation of the US dollar," explains Adrian Lowcock of broker Bestinvest. It is this exposure to local currencies that makes investing in emerging market debt riskier than holding UK fixed-interest investments, says Fahy. "Currency remains a key driver in emerging market debt returns and confidence in emerging market currencies can quickly erode," he observes. Their currencies can quickly move more than 10 per cent and, if an investor is on the wrong side of such a move, then this can quickly nullify any capital appreciation and interest payment. Data from Lipper show that the Investec Emerging Markets Local Currency Debt fund returned -3.47 per cent in the 12 months to 30 June, while the BNY Mellon Emerging Markets Debt Local Currency fund returned -3.94 per cent. By contrast, investors who put money into a UK investment grade bond fund, such as the M&G Corporate Bond fund, would have seen total returns of 8.5 per cent. But while dollar-denominated bonds can remove some of the currency risks, they still present sterling/dollar exchange rate risk for UK investors, and tend offer lower yields. Some advisers therefore favour local currency bond funds, on the basis that emerging market currencies are likely to appreciate over the long term. Returns from these funds over the past three years have been strong. Investec Emerging Markets Local Currency Debt fund, which invests in Turkey among other countries, has returned 33 per cent over the period, while the BNY Mellon Emerging Markets Debt Local Currency fund has returned 32 per cent. "Ultimately, this asset class performs well when investors are more confident and the economic outlook remains positive," says Lowcock. However, others remain unconvinced. Patrick Connolly of AWD Chase de Vere, the independent financial adviser, does not recommend emerging market debt to his clients and says that, if they insist on exposure, it must be in addition to other fixed-interest holdings. "We believe fixed-interest should provide security in a portfolio and aren't convinced that emerging market debt will provide the same level of security as traditional fixed-interest holdings such as gilts or investment grade corporate bonds," he says. Lowcock suggests investors allocate 1 to 2 per cent of a portfolio to emerging market debt. Investors who want to minimise the risk can gain limited exposure to emerging market bonds through more broad-based strategic bond funds. Connolly points out that funds such as Investec Strategic Bond, Kames Strategic Bond and Fidelity Strategic Bond can increase their exposure to emerging market bonds if they believe there are good opportunities. Dennehy Weller and Co say that with the current macro back drop they prefer UK investment grade debt bond funds, such as Fidelity Moneybuilder Income and M&G Corporate Bond, over their emerging market counterparts.