By Tom Lauricella

MENTION THE WORDS "emerging markets" and many investors think of stock markets that rally big one year, only to collapse the next. In the end, many people have decided that emerging-market stocks simply don't sustain the good years long enough to make it worth the stress.

However, another corner of the emerging-market universe has been providing handsome returns with much more tolerable volatility for many investors. Rather than stocks, these funds invest mainly in the government bonds of emerging- market countries. The portfolios span the globe -- from Mexico and other Latin American nations to Southeast Asia, South Africa, Poland, Russia and Turkey.

During the past 12 months, the average emerging-market debt fund has provided investors with a 21% return, according to fund tracker Morningstar Inc. During the past three years, the group has gained an average of 16% annually, and during the past five years, the group has returned an annual average of 8.5%. Perhaps most impressively, it has provided gains in seven out of the past nine years and in each of those seven years the average return has exceeded 10%.

These returns are starting to garner attention. During the first quarter, emerging-market debt funds attracted $452 million of new money from investors after taking in $535 million during 2002, according to Financial Research Corp. But even with the flood of money heading in the door, the category is foreign to many investors At the end of March, emerging-market debt funds held just $4.9 billion in assets. In contrast, California municipal-bond funds hold nearly eight times as much money.

As recently as 2000 and 2001, investors were pulling money out of the category, withdrawing a total of nearly $1 billion over those two years. But fund managers say the fund group has benefited from long-term trends toward improvements in the economies of many emerging-market countries around the globe, despite some headline-grabbing blowups.

"It's striking that if you look at the last five years, that period includes the Russian default, Argentina's default and a very difficult world economy," says Mohamed El-Erian, who oversees $11 billion in emerging-markets debt at Pacific Investment Management Co., including the $1 billion Pimco Emerging Markets Bond Fund. "Despite all that, the asset class has returned about 7% a year."

The success of the emerging-market bond funds contrasts with the returns posted by emerging-market stock funds, whose corporate holdings have had a rockier time than government-issued fixed-income securities. During the past nine years, the average emerging-market stock fund has posted losses in seven of those years. Over the past 10 years, emerging-market stock funds have posted an average 1.4% annual loss.

Despite the stellar returns for the bond category, investors shouldn't lose sight of the risks involved in emerging-market funds. When the bond funds have stumbled, they have fallen hard in the short term. For example, in 1998 when the Russian debt crisis triggered a collapse in bond prices, the average emerging- market bond fund posted a 23% loss.

"Investors have to be able to withstand the volatility -- there's obviously no free lunch," says John Carlson, who manages Fidelity New Markets Income Fund and the Fidelity Advisor Emerging Markets Income Fund, with assets of $725 million and $140 million, respectively. "People who bought in the spring of 1998 didn't recoup those losses until the spring of 2000," he says.

One of the biggest difficulties emerging-markets fund managers say they face is persuading investors that even with disasters within individual countries, such as the financial, political and labor turmoil in Venezuela, the broader trends have been favorable. For example, countries such as Mexico or the nations in Eastern Europe have been initiating market-friendly changes such as reducing inflation, bolstering cash reserves and strengthening their fiscal outlooks.

"In today's globalized economy, if you don't pursue prudent macroeconomic policies, you're not going to attract investment -- either foreign or domestic," says Matt Ryan, who manages $900 million in emerging-market debt at MFS Investment Management, including the MFS Emerging Market Debt Fund, which was opened to the public in June 2002.

Why has there been such a disparity between the performance of emerging-market bonds and stocks? For starters, when governments and their economies run into trouble, they can raise or lower interest rates, adjust fiscal policy or even seek support from outside institutions such as the International Monetary Fund. Publicly traded companies, on the other hand, have fewer cushions. "Countries don't go out of business, but companies can," says Fidelity's Mr. Carlson.

As a result, the credit quality of many emerging-market countries has improved substantially Over the past five years, fund managers say the group has experienced more debt upgrades than downgrades and today about 40% of emerging- market debt is investment grade, up from less than 10% five years ago.

In turn, that improving credit quality has translated into higher bond prices and lower volatility. "Better fundamentals have been the main driver," Pimco's Mr. El-Erian says.

Another support for the category has been the hefty yields offered by emerging-market bonds, which have ranged between 8% and 14% in recent years. That income acts as a substantial cushion to price declines. "You get paid to wait," Mr. Carlson says.

Still, emerging-market debt remains more volatile than the debt of developed countries. As a result, even for investors who can stomach considerable ups and downs, fund managers say a little dab of emerging-market debt in a portfolio will do -- something in the neighborhood of 5% of assets often is enough.

"These funds do not have your typical amount of bond-fund risk -- if you're a retiree looking for a conservative bond offering, this is not a good place to be," says Emily Hall, a senior mutual-fund analyst at Morningstar. "The way to think about these funds is to treat them as a diversifier, like you would a real-estate or precious-metals fund. They're funds that tend not to move exactly in tandem with the equity markets."

In addition, the recent big gains in emerging-market bonds have some managers expressing near-term caution about certain segments of the market. "In some cases you have mature economies where investors have priced in nothing but good news," Mr. El-Erian says. "And in others you have weak fundamentals, but the tide of money coming into the market has raised all boats."

Even against the backdrop of the group's historical returns, investors should be wary of extrapolating from gains posted in recent months. "A lot of investors are always tempted to get into an asset class after they have amazing runs, and especially when it's something that's a niche like this, performance-chasing can really set you up for heartbreak," Ms. Hall says.

The sector has "had a great run and it's almost impossible for emerging-market debt to outperform the way it has been," MFS's Mr. Ryan says. But with yields on these bonds hovering around 8% or 9%, "the asset class should continue to deliver decent returns."

Copyright (C) 2003 Dow Jones & Company, Inc. All Rights Reserved.