Kristin Ceva says emerging markets are likely to keep creditors happy.

Americans have poured billions of dollars into emerging market bond funds this year in their global search for high yields. Are they setting themselves up for disaster as developing countries revert to their bad old habit of stiffing foreign creditors?

Not likely, says Kristin Ceva, comanager of the $635 million (assets) Payden Emerging Markets Bond Fund. Ceva, who holds a Stanford Ph.D. in international politics and studied Mexico's financial system as a Fulbright scholar, undoubtedly has an interest in talking up emerging markets. But she also makes an impressive case that they offer attractive fixed-income deals relative to the U.S.

The balance sheets of many developing countries' governments, she notes, are far healthier than Uncle Sam's. Total emerging market government debt averages less than 50% of gross domestic product, compared to more than 100% for the G3 (the U.S., Europe and Japan). Meanwhile sovereign emerging market bonds (about half of which are investment grade) are paying around three percentage points more than the 2.5% investors can earn from the comparable ten-year U.S. Treasurys.

"On any measure of debt sustainability, whether it's GDP, overall debt levels or GDP growth, the emerging countries are about twice as good as what you're seeing in developed markets," says Ceva.

There are risks, of course. Many of the countries Ceva is investing in have defaulted or restructured debt in recent years. The Asian financial crisis sent the value of emerging debt into a tailspin in 1997. A year later Russia defaulted on its domestic debt and halted bank payments to foreign creditors. The Dominican Republic restructured its foreign debt a mere five years ago.

Another reason for caution is that the popularity of emerging market bonds itself increases the risks. Americans have hiked their holdings of emerging market debt nearly sevenfold over the past decade to $34 billion, including a $5 billion inflow this year alone, according to Lipper Analytics. It's probably no coincidence that during that time emerging market bond funds have returned an annual average of 11.5%, or more than twice the 5.2% bond fund average.

As prices have risen yield spreads over Treasurys have narrowed for sovereign emerging market bonds. Their three percentage point yield premium means the emerging bonds are hovering close to their long-term average but double where they were during the frothy precrash days of 2007.

Pricing may not yet be flashing red, but there are other concerns. Foreign investors have gotten fleeced in the past as inflation in places like Brazil and Turkey has undermined the value of local currencies relative to the dollar. Investors can limit such risk by buying greenback-denominated "dollar pay" bonds. Owners still get burned, of course, if the issuer fails to come up with the dollars to honor its debts. That helps explain why spendthrift Venezuela was forced to offer a whopping 15.25% coupon in August to unload $3 billion worth of dollar-pay bonds.

So far, the dollar-pay pool is shallow, with only about $500 billion worth outstanding. That compares to $2.5 trillion worth of local denomination emerging market bonds, Ceva says.

One way to limit the risk that inflation will undermine the dollar value of your bonds is to invest in an index fund diversified across emerging markets or by sticking with a manager who you're confident knows the ropes (Payden Emerging Markets Bond Fund rates an A from FORBES in down markets and a D in up markets).

"You do have to be comfortable when making a local-market investment that the central bank is going to be an inflation fighter," Ceva says. "I don't think that is much of an issue right now. Brazil, for example, has been pretty aggressive."

Before buying corporate or sovereign emerging market bonds, the Payden team examines macroeconomic and political indicators like the strength of the banking system, economic growth potential and exchange-rate stability. Indonesia, Ceva notes, temporarily suspended foreign debt payments after the 2004 tsunami. It has shown an impressive ability since to stimulate domestic demand, which Ceva believes will accelerate economic growth and insure that the government continues to pay 9% on rupiah-denominated bonds.

Ghana's local-pay bonds yield 13%, despite its status as a democracy with abundant offshore oil reserves. Ceva believes even Mexico has stabilized its finances amid widespread violence and a history throughout the 1980s and 1990s of staggering from one financial crisis to the next. Mexico may raise interest rates next year, she says, which would likely cause the peso to rise against the dollar.

Where Ceva draws the line is at bonds rated CCC or less by Moody's and Standard & Poor's. She also shuns countries she thinks lack the political discipline or will to defend their currencies and keep paying creditors in a crisis.

"Ecuador has shown a willingness problem," she says.

As investors have learned the hard way, problems in one emerging market have a way of spreading to others when they're least expected to do so. Peter Demirali, a portfolio manager at Cumberland Advisors, a $1.5 billion (assets) fixed-income manager based in Vineland, N.J., believes Mexican dollar-pay bonds yielding 3.8% offer a paltry return for handing over your assets for ten years to a government plagued by narco wars, corruption and political instability. Instead, he's advising clients to buy taxable Build America bonds issued by the ports of Seattle, New York and New Jersey. With a yield of 4.3% those bonds are paying 0.5 percentage points more than the lower-rated dollar-pay debt issued by the government of Brazil.

"If you're a U.S. investor with U.S. liabilities, why would you take that [emerging market] risk?" Demirali asks. "Wouldn't you want to own the New Jersey Turnpike or the Port of Seattle bonds to pick up yield?"

Fortunately for investors who find both arguments convincing, it's always possible to split the difference and invest in both markets.

#### Safe Plays

Emerging market investors face the risk that prices will tank, governments tumble and currencies weaken. Even so, these foreign bond funds provide better yields than youÕll get at home, plus impressive down-market records.
performance |  | total return |  |  |  |
up mkt | down mkt | fund | 5-YEAR ANNUALIZED | LATEST 12 MONTHS | ASSETS 10/31/10 ($MIL) | yield | Annual expenses per $100 | Minimum initial investment
D | A+ | Artio Global High Income-A | 9.1% | 16.1% | $3,094 | 7.3% | $1.00 | $1,000
D | A | Eaton Vance Strategic Income-A | 7.4 | 8.8 | 2,855 | 5.2 | 1.08* | 1,000
C | A | Fidelity New Markets Income | 10.6 | 15.3 | 4,592 | 6.2 | 0.95 | 2,500
D | A | Payden Emerging Markets Bond-Inv | 9.4 | 18.4 | 443 | 5.1 | 0.85 | 100,000**
C | A | T Rowe Price Emerging Markets Bond | 9.5 | 17.4 | 2,713 | 6.4 | 0.97 | 2,500
B | B | Templeton Global Bond-A | 12.4 | 14.0 | 42,635 | 4.2 | 0.94*** | 1,000
Performance through Oct. 31. *Maximum sales charge of 4.75%. **In November 2009 fund rolled out an adviser class with a minimum initial investment of $5,000. ***Maximum sales charge of 4.25%. Sources: Forbes; Lipper.