A bit player in the world of mutual funds looks ready to try out for a larger role. The performer in question is the emerging-markets bond funds population, which started out small in the early 1990s and has stayed that way. Until recently their obscurity seemed utterly justified. While professionals and sophisticated individual investors found many uses for individual bonds issued by governments and businesses of developing economies from Russia to Brazil, something got lost in translation into the mutual-fund format.

These bonds’ yields are high often 10 percent or more at a time when comparable bonds from U.S. issuers pay little more than half that much. They can also offer nice diversification benefits.

Trouble was, when managers packaged emerging-markets bonds in a mutual fund, they got a product in search of a customer. The potential payoff, it seemed, was too limited to appeal to aggressive, growth-minded fund investors; the risks and volatility were too great for most conservative investors with income and safety uppermost in their minds.

So not much happened. Eight years after the first of these funds appeared, Morningstar tracks 40 such funds with combined assets of $3.2 billion.

For perspective, that’s only one-fourth of the money in emerging-markets stock funds. Of each $100 invested in bond funds of all types, 37 cents is entrusted to emerging-markets bond funds.

The Fidelity New Markets Income Fund, the emerging-markets bond entry from the biggest of all mutual fund stables, reported assets of $283.9 million at the end of its first year, 1993. As of July 31, 2001, the total was still stuck at $283.2 million despite an average annual total return over the fund’s life of 12 percent.

Well enough alone

If it weren’t for performance numbers like that last one, it might make sense to let these sleeping dogs lie. History shows that whenever conservative fund investors try anything exotic, they’re asking for trouble.

The returns, however, argue that attention should be paid. Going into the last week of August, the Morningstar average annual total return for emerging-markets bond funds was 16.9 percent for the past three years, 10 percentage points better than any other category of bond funds.

Admittedly, that starts from a low base, coming out of the financial crises in Asia and Russia of 1997 and 1998. Emerging-markets bond funds had an average drop of 23 percent in 1998, as measured by Morningstar, which tells you something about how severe their ups and downs can be (see also 1994, down 14 percent).

Still, the recent performance invites comparisons with domestic “junk bond” funds at the start of the 1990s. They rebounded from a crisis in their market, then went on an extended run of good returns. Today, domestic high-yield bond funds have assets of $84 billion, and these bonds have become a standard item on the financial menu.

Could it be that emerging-markets bonds are now traveling the same road to respectability? Look at the strides made by a major issuer of this sort of debt, Mexico.

Early in August, Mexico sold $1.5 billion of 30-year bonds at an annual yield of 9 percent, a level that indicated investors weren’t in the least put off by worrisome developments then unfolding elsewhere in Latin America, notably in Argentina. One investor with a taste for big risks who spoke with Bloomberg News at the time said he was no longer interested: “Mexico is too good quality.”

Let’s be clear conservative income-minded investors can’t afford such insouciance. A paragraph in Fidelity’s monthly Mutual Fund Guide describing the risks in New Markets Income lists a dozen hazards that should never be overlooked.

“Risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies,” said one particularly pertinent sentence.

Even so, this is a time of potential “yield shortage,” when yields from traditional sources in stocks, bonds and the money markets are at a low ebb while demand for income-producing investments stands to increase as the investing population ages.

Emerging-markets bonds represent one possible answer to that problem. That promises to make them harder to ignore.

Chet Currier is a columnist with Bloomberg News.