MFG: John, you’ve been involved in emerging markets for nearly 18 years now, since the early days of the modern era for emerging-markets debt. What initially led you to focus on emerging markets?

Carlson: My interest in emerging markets actually began nearly 20 years ago with a trip to Buenos Aires, Argentina. That trip opened my eyes to the investment opportunities in developing markets. In turn, this had a profound impact on my career. At the time, I had been working on Wall Street for about 10 years, and after returning from Argentina I began to explore the profound changes occurring in emerging markets around the world. Shortly thereafter I joined Lehman Brothers, first to build the firm’s Latin American fixed-income trading desk and then to cover emerging markets in Eastern Europe, the Middle East and Africa. In June 1995, I was fortunate to be tapped by Fidelity to run New Markets Income — which had been launched two years earlier as the first U.S. mutual fund dedicated to emerging-markets debt.

MFG: What kind of opportunities did you see in Latin America that convinced you to focus on emerging markets?

Carlson: Political and economic reforms were starting to take hold in a number of Latin American countries after years of high debt levels and hyperinflation. The region was also benefiting from a growing population and rising demand for its abundant natural resources. I saw outstanding prospects for growth in Latin America, which was emblematic of changes taking place throughout the emerging world.

MFG: Your hunch proved right. Emerging markets have enjoyed strong growth and increasing prosperity in recent years. How does emerging-markets debt differ today from 10 or 15 years ago?

Carlson: The past 15 years or so have seen dramatic improvements in the credit quality of emerging-markets debt issues. Increased global trade and rising demand for commodities have contributed greatly to an improved credit profile. In fact, in 1994 only about 2% of emerging-markets debt (as measured by the JPMorgan Emerging Markets Bond Index Global) was rated as investment grade, compared with more than 50% today.

MFG: Does that mean the profile of the New Markets Income Fund also has changed in recent years?

Carlson: The maturation of the asset class has provided a host of new opportunities. When the fund was first established in 1993, there were only a handful of countries represented in the emerging-markets debt universe, compared with over 35 today. Additionally, as emerging countries demonstrated success in servicing their U.S.-dollar-denominated obligations, markets for local-currency debt and emerging-markets corporate bonds have grown as well. So the change in the fund’s profile reflects not only the generally higher credit quality of sovereign issuers but also the increased breadth of investment opportunities.

MFG: These emerging economies are located across the globe, so gathering information must be an important part of the job. How has the flow of information changed over the years?

Carlson: When I first started managing the fund 15 years ago, the Internet was in its infancy, so it was not a primary information source. Back then, I spent as much time gathering information as I did analyzing it and drawing inferences from it. I relied heavily on personal contact — either in-person visits or phone calls with people in developing markets around the globe. Today it’s almost impossible to conceive of doing this job without a constant stream of information flowing in from sources around the world. But ubiquitous information is not always good information. The key is inference — what one makes of the information. The more experienced your investment team is, the better able you are to filter out the noise and parse worthwhile information into investment insights. That’s what we strive to do every day — use the research and expertise available to us to make the best investment decisions for our shareholders.

MFG: You mentioned the breadth of investment opportunities in emerging markets. Can you give some insight into what you look for in deciding where and how to invest?

Carlson: We look for countries or companies with strong balance sheets, good management or political leadership, and attractive growth prospects. We constantly assess where the global economy is going and where local economies are headed. It’s important to understand regional strengths and weaknesses since a lot of trade is regional. We also focus on local-market yield curves, currency reserves, and what governments, central banks and finance ministers are trying to achieve — whether they are worried about their economy overheating or are trying to stimulate the economy. These are just a few of the factors that play into our decisions.

MFG: What’s your process for identifying investment opportunities?

Carlson: We have two primary objectives. The first is to seek to avoid large losses on individual investments in the fund. Because these are fixed-income instruments, the upside is largely dependent on getting your money back. Countries don’t go out of business, but sometimes they take a very long time to restructure their debt, so there’s a time-value to that money. The performance on the investment comes from getting a return on your money and, if credit conditions improve, perhaps from some capital gains as well. With this in mind, we have developed in-depth financial modeling capabilities to look at sovereign credits. Much of the work is top-down, beginning at the country level. Before investing in a credit, we want to have a sound understanding of that entity’s ability to make good on its debt-service obligations. But ability to service debt is only part of the equation; there also must be a willingness to do so. That means understanding the country’s history and political structure as well. To get these answers we complement our proprietary models with our own research trips and by leveraging Fidelity’s extensive global research network. Our second goal is to identify undervalued sovereign credits with positive catalysts. Often, these are not easily understood or appreciated. For this, we rely heavily on our experienced research team to recognize and uncover these opportunities. We also layer in a bottom-up approach to examine investment ideas in local-currency bonds and emerging-markets corporate bonds.

MFG: To what extent do you use corporate and local-currency bonds?

Carlson: We use corporate bonds from the higher-credit-quality countries to add value and broaden diversification. We also can invest in convertible bonds, distressed debt and equities. We keep at least two-thirds of the portfolio in U.S.-dollar-denominated government bonds at all times. Therefore, the combination of local-currency bonds, equities and corporate bonds will not exceed one-third of the fund’s assets.

MFG: So currency values play an important role in your investment decisions?

Carlson: Yes, but we don’t engage in any currency hedging in the portfolio. This is predominantly a U.S.-dollar-denominated fund, and it is benchmarked against a U.S.-dollar-denominated index. Still, I think it’s important to consider the outlook for local currencies versus the dollar, because currencies are a reflection of a country’s economic prospects. As an example, last year we had significant exposure to local currencies early in the year, and we unwound most of those positions late in the year when the outlook for the U.S. dollar appeared relatively more favorable. Ultimately, we need to be comfortable with the prospects for a country’s currency valuation before investing in the local-currency debt.

MFG: This investment process has helped to deliver impressive results. In 2009, New Markets Income was up 44.6%, compared with a 28.2% gain for the JPMorgan index. What was behind the stong performance?

Carlson: In 2009, the fund benefited from both the steps we took in 2008 to position for an economic downturn and the moves we made late in 2008 and into 2009 to prepare for an eventual recovery in world markets. After Bear Stearns failed in March 2008, I became more concerned about the U.S. financial system and started to raise cash and take more-defensive positions in the fund. By the time the financial crisis erupted in full force in the fall, I had positioned the fund in a relatively defensive fashion, with high cash levels and more liquid holdings. That wasn’t enough, however, to fully protect the fund from the severe sell-off in emerging markets in 2008. But as emerging-markets debt prices declined and yield spreads increased late in 2008, I became more optimistic than most of my peers and gradually began taking advantage of what I felt were some seriously undervalued bonds. By the spring of 2009, I had shifted from a risk-adverse posture to a more aggressive position and was able to take advantage of some opportunities in bonds that had underperformed during the market sell-off. Some of the issues I increased exposure to included sovereign bonds of the Ukraine as well as Brazilian and Russian corporate bonds, prices of which had declined sharply in 2008 but rebounded nicely in 2009. Of course, it’s important to keep in mind that past performance doesn’t guarantee future results.

MFG: Can you give an example of a country that performed well for the fund?

Carlson: Sure. Early in the year I saw some compelling opportunities in Venezuela. Venezuela sovereign debt was trading at default levels. Yield spreads were 1,500 basis points (15 percentage points) higher than U.S. Treasuries, so I felt there was limited downsize risk and tremendous upside. On the other hand, Mexico, which is closely tied to the U.S. economy, was only yielding a little over 400 basis points more than Treasuries. There was a huge difference in the potential opportunity. So, I overweighted Venezuela and underweighted Mexico (relative to the JPMorgan index). That positioning benefited shareholders, as the Mexican market was up only about 12% and Venezuela solidly outpaced the index with a return of roughly 62%.

MFG: What other countries contributed to New Markets Income’s results in 2009?

Carlson: The fund also benefited from overweighted positions in Argentina, the Ukraine, Russia, and the Ivory Coast, as well as an underweighting in Brazil. Over the course of the year, however, some of these positions reversed, as I felt the bonds and equities of higher-rated sovereigns offered better relative value than securities of some of the lower-rated countries that had performed well for most of 2009.

MFG: Given the strong returns in 2009, are you cautious about the outlook for emerging-markets debt in 2010?

Carlson: Yes, I’m cautious, but certainly not pessimistic. Clearly, after such a strong run in 2009, the opportunity set for emerging-markets debt has narrowed. The U.S. dollar has been weak, so local-currency investments have done well versus the dollar. Interest rates have remained low and there has been a flood of liquidity that has lifted all boats. But this liquidity is now gradually being taken away. So I think 2010 could be characterized by both winners and losers in emerging markets. That could actually play to the advantage of New Markets Income, since the fund draws on Fidelity’s vast research and experienced investment professionals to help uncover investment opportunities around the world.

MFG: What makes you cautiously optimistic about the prospects for emerging-markets debt?

Carlson: I believe U.S. interest rates and inflation are likely to remain low for most of the year. Interest rates in developing countries generally have been subject to local conditions and monetary policies. It’s hard to characterize the outlook for emerging markets as a whole, since the market is so diverse. But, as long as rates remain low in the U.S., I think we could see continued appetite for emerging-markets debt. Consider also that the emerging world represents the engine for global economic growth. On the other hand, the developed world is in the midst of a likely prolonged period of relatively slower economic growth and rising government debt. People have long thought of emerging markets as risky, but that perception probably deserves to be revisited in light of the fact that the sphere of economic influence is shifting.

MFG: What might cause you to become less optimistic?

Carlson: There are always a number of uncertainties when investing in emerging markets. Probably the biggest risk to the near-term outlook for emerging-markets debt would be if the global economy moves to one of two extremes — with robust growth causing inflation to pick up more than expected or, at the other extreme, a faltering economy causing credit quality to deteriorate. At this point, I don’t think either scenario seems likely for the near term.

MFG: What trends or investment themes are you following?

Carlson: We continue to use the same time-tested process we always have. That is, when assessing corporate or sovereign debt, I’m looking for strong balance sheets, good management and favorable growth prospects. As we get further from the downturn of 2008-09, we’ll likely continue to see some countries faring better than others. As I said, I think success in 2010 is likely to depend on choosing between the winners and losers, and the differentiation between the two could be greater than in 2009.

MFG: What sort of investor might consider owning New Markets Income?

Carlson: New Markets Income is intended for investors seeking current income with the potential for capital appreciation, as well as exposure to global fixed-income markets as part of a diversified fixed-income portfolio. I have to stress, however, that emerging markets are volatile, so this is not the right fund for anyone who has a short-term investment horizon or can’t stomach some volatility. Since I’ve been managing the fund, we’ve had the Mexican debt crisis, the Russian crisis, the Asian crisis, and defaults in Ecuador and Argentina. But, emerging markets have survived each crisis, and New Markets Income has produced attractive returns over the life of the fund, as well as the most recent one-, five- and 10-year periods.

MFG: Any closing thoughts?

Carlson: I would simply say it’s not too late to get involved in emerging markets, particularly if you believe that developing countries may continue to benefit from increasing global trade and economic development. Emerging markets — both equities and fixed income — have produced impressive returns for investors over the past two decades, though there have been fits and starts along the way. While investors can’t count on the kind of spectacular returns we saw in 2009, limited exposure to emerging markets may be well worth considering as part of a balanced, diversified portfolio.

MFG: Thanks, John. We appreciate your time.