Emerging market bonds are attracting significant investor attention, when more than $10 trillion of the safer developed market government bonds are offering negative yields. Though the recent rise in demand for emerging market bonds led yields on the same to decline, these are still offering significantly higher yields compared to what is being offered by developed market bonds. Hence, there is enough scope for yield-starving investors to derive impressive returns by investing in these debt securities.

Investing in mutual funds that offer significant exposure to emerging market bonds may prove to be a prudent option against this encouraging backdrop.

EM Bonds Attracting Notable Attention  

For the week ending Jul 20, emerging market bonds registered an inflow of around $4.92 billion, the highest in history, according to a Bank of America Merrill Lynch report. This was preceded by an inflow of $2.69 billion witnessed a week earlier. Separately, emerging market bond funds witnessed a record inflow of $4.7 billion last week, witnessing the highest inflows since 2004, as per JPMorgan Chase & Co. (JPM - Analyst Report) .

The Lipper report released yesterday also supported the fact. According to Lipper, U.S. based funds focusing on acquiring emerging market debt securities saw inflows of $1.4 billion for the week ending Jul 27, the highest level since 1992. It was preceded by an inflow of $918 million recorded earlier week. Moreover, this encouraging environment helped the largest emerging market bonds ETF, iShares JPMorgan USD Emerging Markets Bond (EMB - ETF report) , to registered inflows of $1.34 billion and $2.14 billion over the past one month and three-month periods, respectively. Also, growing demand for these securities led mutual funds from this category to return 3.08% and 10.9% in the trailing one-month and year-to-date frames, respectively, according to Morningstar.

Attractive Yields on EM Bonds

Rising demand for emerging bonds pushed yields on sovereign bond from emerging markets to a record low level of 4.47%, according to Bank of America Merrill Lynch. However, the yields remain higher than developed market bonds. The U.S. 10-Year Treasury bond yield is currently around 1.5%. Despite a decline, average emerging market bonds yield remained at higher level of 7.45%.

Moreover, corporate junk bonds in emerging markets returned nearly 14.2% in the year-to-date frame, which is fairly higher than its developed counterparts. The U.S., euro and sterling junk bonds gained 12.5%, 5.7% and 5.6%, respectively, during the same time frame. Also, yield on Brazil’s 10-year bond is nearly at 11.7% due to dismal domestic economic conditions and high levels of interest rates.

Reason for Rising Demand

Financial markets took a major hit following June’s Brexit referendum that led yields on developed market government bonds to decline on a surge in demand for these less risky securities. So, emerging market bonds drew investor attention due to their higher yields. Emerging markets are also speculated to get less affected by Brexit. Moreover, large exposure to commodities also helped emerging markets to surge recently on the back of rising commodity prices. A staggering performance was delivered in the first half by Latin America and Russia. While Russia benefitted from an oil price rally, Latin America won on stronger commodities and hopes of a political change for the better.

Separately, ongoing quantitative easing programs in major economies like Europe and Japan also made yields on their government bonds less attractive. Though the Federal Open Market Committee (FOMC) signaled that the Fed may opt for a rate hike this year, it took a cautious stance and kept the key interest rate unchanged in its July policy meeting. This is expected to give further boost to demand for emerging market bonds.

The head of research services for Thomson Reuters Lipper, Tom Roseen said: "You have this possibility of interest rates going up in September, but you also have easing going on in the rest of the world, so this is probably something that is good for emerging markets."

3 EM Bond Mutual Funds to Buy

Given this encouraging backdrop, we have selected three emerging market bond mutual funds that either carry a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy). We expect these funds to outperform their peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund.

These funds have encouraging year-to-date, one-year and three-year annualized returns. The minimum initial investment is within $5000. Also, these funds have favorable expense ratios and no sales loads.

T. Rowe Price Emerging Markets Bond (PREMX - MF report) invests a large chunk of its assets in government and corporate bonds from emerging markets. PREMX has year-to-date, one-year and three-year annualized returns of 14.2%, 14% and 5.6%, respectively. It has an expense ratio of 0.93%, lower than the category average of 1.16%. This Zacks Mutual Fund Rank #1 product has an annual dividend yield of 5.7%.

Fidelity New Markets Income (FNMIX - MF report) invests the lion’s share of its assets in securities from emerging markets, per MSCI and the World Bank. FNMIX has year-to-date, one-year and three-year annualized returns of 13.7%, 12.5% and 5.9%, respectively. It has an expense ratio of 0.84%, lower than the category average of 1.16%. This Zacks Mutual Fund Rank #2 product has an annual dividend yield of 5.1%.

Goldman Sachs Emerging Market Debt IR (GSIRX - MF report) invests a major portion of its assets in debt securities including both government and corporate bonds of emerging market countries. GSIRX has year-to-date, one-year and three-year annualized returns of 12.5%, 12.8% and 6.8%, respectively. It has an expense ratio of 0.98%, lower than the category average of 1.16%. This Zacks Mutual Fund Rank #2 fund has an annual dividend yield of 4.5%.