Dangers lurk beneath the attractive surface of emerging market gilts

With UK gilts paying next to nothing and continued worries over the debt of the eurozone countries, investment companies are gearing up to sell funds which invest in the government bonds of emerging economies.

These funds are presented as a safer way to gain exposure to the emerging economies, while offering high returns of around 6 or 7 per cent a year. But are they safe?

"It is right people take a cautious tone and understand the risks compared to more traditional types of funds," says Adrian Lowcock, a senior investment adviser at Bestinvest. "Although there is a long-term opportunity here, they aren't like other debt funds – they are far from suitable for everyone."

Mr Lowcock also warns that a lot of these new funds, and in some cases managers, do not have a track record. "Some launch funds to capture a trend," he says. "So you want a fund manager who has spent time running it and can prove they know what they're doing," he adds.

There is also the wider danger of a eurozone country default, which would harm the market in emerging, as well as Western government, gilts.

Nevertheless, the emerging markets story is a compelling one for investors and it follows that the government bonds of these countries will also appeal. "There are several attractions of investing in emerging market debt," says Ben Willis, an investment manager at Whitechurch Securities. "There's the potential for appreciating currencies, solid returns of around 6 or 7 per cent at present, and they are relatively unexposed to the sovereign debt issues that plague Western economies."

But, a recent report from the ratings agency Fitch shows that only the top 25 per cent of emerging market debt funds delivered positive returns last year.

"Despite the debt dynamics of emerging market governments, their debt isn't deemed a safe haven in nervous market conditions," says Brian Dennehy, the managing director of Dennehy Weller & Co. If you seek safety, then it's not just a case of looking for a government that won't default, but also having bonds you can easily sell if necessary.

But, history shows there have been plenty of defaults and economic crises in emerging markets, including the Asian banking crisis in the Nineties, plus Mexico's and Argentina's defaults the following decade. Although the Bric countries – Brazil, Russia, India, China – are powering ahead, not every emerging market will continue to grow nor will each government be able always to pay its debts. "Emerging market debt must be considered relatively high risk, as we are dealing with economies many of which are going through structural changes," says Mr Willis. "Also, in several countries there is a precedent for political risk."

But, these bonds can play a useful role in a portfolio. "Emerging market debt provides diversification away from traditional bond funds," says Meera Patel from Hargreaves Lansdown. "But, I would caution investors that they should not be tempted purely by the headline yields on offer."

Emma Dunkley is a reporter at Citywire.co.uk

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