The threats of tapering quantitative easing by the U.S. Federal Reserve has led risk assets being sold off. Cash has flooded emerging markets since QE1 was first initiated in 2008, turning cheap borrowing into high returns which was then invested in risky emerging market equities and bonds.
But this tide of cash will subside once the Fed cuts back on its stimulus however, and in a pre-emptive move the value of emerging market debt fell in the months after the May announcement in which Fed chairman Ben Bernanke first floated the idea of tapering.
Once the U.S. Federal Reserve starts reining in its purchase of U.S. bonds, there is going to be less liquidity around, less liquidity to go into the more risky areas of the market, such as emerging market bonds. Investors have been scared about this and have been kind of selling down their exposure to this perceived high-risk asset class.
This slump - the first time emerging market debt funds have lost cash in five years - has presented a buying opportunity. Investors should remember that emerging market debt is a volatile asset and should only be allocated a marginal part in your portfolio. For those willing to take on the risk for the chance of a high income reward, here are the Morningstar analysts' top-rated emerging market debt funds.
Templeton Emerging Markets Bond
Rated: 
Silver
We believe the Templeton Emerging Markets Bond fund is a compelling offering within the sector, said Morningstar analyst Anthony McDonald.
We like several things here. Fund manager Michael Hasenstab is experienced and has been involved in the fund’s management since 2002, becoming lead manager in 2006 and more recently receiving official support from new comanagers Marco Freire and Laura Burakreis. In our view, his expertise at macroeconomic analysis contributes to the strength of the offering, which is further supported by a very well-resourced team of portfolio managers and analysts that incorporates on-the-ground presence in key markets. We think this is a well-sized team that provides Hasenstab with the resources he needs to run this offering well.
Pictet Global Emerging Market Debt
Rated: Bronze
Pictet-Global Emerging Debt benefits from its defensive qualities, said Morningstar analyst Natalia Wolfsetter.
Apart from hard currency bonds in US dollars, the fund can add up to 30% in local bonds and currencies from emerging markets. During times of crisis, fund manager Simon Lue-Fond rotates into developed markets to limit losses. These have been used to great effect in 2008 and 2011 to limit downside risk, which gave the fund a substantial advantage compared with the average fund in the Global Emerging Markets Bond Local Currency category. Contrary to expectations, however, the long position in US dollars in the current year has delivered rather mixed results. On the other hand, the underweight duration for bonds of large issuers with low risk premiums and a high correlation with rising US yields such as Brazil paid off. The short position in local currencies also benefited the fund.
