Emerging Market Debt: Sorting though the ‘stuff’
In an asset class dominated by top-down commentary, Martin Steward finds bottom-up alpha defining performance
This month's table of performance data from Mercer is one of the more interesting to have featured in our ‘Investing in' series. Our top performer, GMO, is dominant across the three-year, 12-month and 3-month horizons, but the really intriguing thing is the consistency through both the summer of 2011 and the winter of 2011-12. Most of the managers in the table did well in one of those periods, but not both and, not surprisingly, the majority performed best in the rankings during Q1 2012, when markets were rallying.
ING Investment Management, in eighth place over three years, did better over 12 months than over Q1, as did Federated Investors in tenth place - but both were less consistent than GMO. Fidelity/Pyramis in fourth place over three years and Aberdeen Asset Management in seventh were quite consistent over the two shorter horizons, but slipped down the rankings during the choppiness of 2011.
This is not an observation about how brilliant GMO is at sustaining great returns from one quarter to the next. Q2 2012 has been a struggle: the two worst performing countries in the JPMorgan EMBI Global index were Argentina (down almost 9%) and Venezuela (down 4.7%), two of GMO's major positions. It is, rather, an observation about the dominance of alpha in its risk.
"Because of the overwhelming contribution of bottom-up instrument selection, we are just going to look very different," as portfolio manager Tina Vandersteel puts it. "Most other portfolio managers like to come up with some view about the world, or some likely trajectory for a country."
Indeed, the Q2 performance was dominated by top-down issues: plummeting confidence in Argentina off the back of protectionism and the forced nationalisation of energy company YPF; and Venezuelian president Hugo Chávez spending on election gifts and promising to make his socialist revolution irreversible. GMO, focused on security-specific, long-term value opportunities, does not go out of its way to avoid any country that looks like a liability.
"Because we are bottom-up managers we are involved in credits that span the gamut from single-A borrowers to basket cases," says Vandersteel. "So my key criterion is price. If I bought a deteriorating credit at a price that more than anticipated that deterioration, that would be fine."
Or, to put it crudely, if your basic starting point is to find the cheapest bonds in the emerging world, it doesn't really matter if you experience a default - because the bond you hold will be the one closest to recovery value.
As Vandersteel explains, the relative preponderance of ‘unloved' securities and countries in her portfolio leads her into some of the most illiquid and complex parts of the markets. That predicates and defines the long-termism of the strategy, and also Vandersteel's focus on the only two outcomes that she regards as relevant - full payment or default. In either case, the illiquidity discount from which the portfolio benefits realises a return, but on the way many holdings will become ‘untradeable' and very volatile. This is why the portfolio's beta is high at 1.20, and also why its ranking slips to 33rd out of 55 over the five-year horizon that includes 2008.
When we look at the Fidelity/Pyramis strategy that also achieved consistency over the three and 12-month horizons, it is not surprising to find a similar philosophy.
"We like to describe ourselves as value-oriented, long-term investors, who try to buy and hold," says portfolio manager Jonathan Kelly. "We believe that there is a significant illiquidity premium in credit generally, but especially in emerging market debt, and that our job is to figure out the most prudent and efficient way to earn that premium. If we compare what we're doing with our peers, I'd say we are more credit than currency focused; we are looking at sovereign and corporate issues that we believe are perhaps less liquid and less understood by the Street, to buy, hold and ride through that illiquidity. We had a very weak period in 2008, followed by a very strong period in 2009, and that would be emblematic."
The nature of this kind of strategy has changed a lot over recent years, Kelly notes. Not long ago there would have been plenty of bottom-up security-selection alpha available, even among the highest-quality issuers, but now these curves are pretty efficient and well-maintained. Kelly says that the real difference is made in lower-quality, less-well-researched issuers. "Good examples might be Argentina and Venezuela, where we do find very rich instrument-selection alpha," he adds.
Argentina and Venezuela - the two big overweights that caused GMO so much pain in Q2 2012. "Argentina and Venezuela are such tremendous basket cases that they throw up fantastic instrument relative-value opportunities," says Vendersteel. "A high-quality country's yield curve looks nice and smooth because they issue debt all the time and they don't want to issue debt cheaply. Argentina hasn't issued a bond internationally since they defaulted back in 2001, so it's yield curve is hardly a curve at all - it's just a bunch of stuff."
From among that stuff GMO has built a 6.5 percentage point overweight with euro-denominated bonds that emerged out of Argentina's debt restructurings in 2005 and 2010. Sold by European investors glad to get anything back from the 2001 default, these bonds trade just above 20c with four percentage-point bid-offer spreads. Once you've bought them, you really need to hang on to them, and that is where the discount comes in: Vandersteel has serious concerns about another Argentinian default, which is why she eschews the more liquid issues trading in the 80s.
At first glance, Kelly's approach to his 5.4 percentage-point overweight looks very different. "Argentina may not be a great 20-year story but we think it's a perfectly good 3 to 5-year sovereign credit story," he says. But he is not blasé about default risk. Firstly, he is focused on short-dated issues - 70% of his holding will amortise by 2015.
Secondly, he likes local-law US dollar bonds. These offer less protection than New York-law bonds in a default, but because they were issued by the Kirschner administrations and are mostly owned by domestic investors Kelly thinks that the government will continue paying out on them even if they do default on foreigner-owned bonds.
They implement their Venezuela overweights differently, too. Vandersteel builds her 3.1 percentage point overweight with New York-law US dollar bonds bought in the secondary market. Why? Because the domestic investors who buy them immediately flip them to European and US investors at 75-80 cents on the dollar, desperate to get their hands on greenbacks.
"It's better than buying dollars in the black market, which will cost you a premium more like 50% and the possibility of ending up in a Venezuelan jail," she observes.
While Kelly acknowledges this theme in Venezuela, he prefers the 100% state-owned oil company PDVSA. Its 2014 and 2017 bonds are where he has most of his 4.5 percentage point overweight. "The long end of the curve trades flat to the sovereign curve, and in some cases even through the sovereign," he says. "But at the front end there's not only a nice premium, it's also a steep curve, so you get a great roll-down, too."
The JPMorgan benchmark indices include a weighting of about 20% in quasi-sovereign issuers - including wholly state-owned companies. At GMO, Vandersteel looks for 50-300 basis points of spread from her 20% holding in these quasi-sovereigns - which means hunting for stronger credits in weaker countries or weaker credits in stronger countries - but steers clear of pure corporates. "They're just too risky and you don't get paid enough to take those risks," she says.
The Fidelity/Pyramis portfolio, by contrast, goes well beyond the quasi-sovereigns to commit 15-25% to outright corporate credit. Fidelity's 500-plus army of global equity analysts gives Kelly confidence that he can find the value that Vandersteel prefers to seek in more eccentric sovereign paper.
"We're looking at good-quality countries and finding that their dollar sovereign debt yields have gotten extremely low," he says. "That's why we prefer to look at the highest-quality corporates, looking for 200-500 basis points of spread."
While he aims for "reasonable" sector diversification, telecoms has been interesting over recent years. He cites Russian mobile operator MTS: it runs gross leverage of 1.7 times EBITDA and enjoys good margins on $5bn EBITDA from 100 million subscribers, numbers that make it look like the A- rated Verizon, while yielding more like the B+ rated Spread Nextel. "That's the kind of thing we're looking for in emerging markets, and that's what I'd consider our real expertise," he says.
The Franklin Templeton strategy looks a bit like the Fidelity/Pyramis approach writ large, even though it states that country selection is the most important decision in structuring its portfolio.
"What we mean by country selection is that, rather than taking views on the regions, or a top-down view on the oil price or some other macro theme, we take investment decisions about whether we will be able to meet our return objectives by holding any particular country," explains portfolio manager William Ledward. "Then, within that country we make specific security selections."
Security selection is indeed important. In Venezuela, Ledward has the plain-vanilla 2020 bond, but most of his position is in a high-yielding, oil-linked warrant. Argentinian exposure has recently been built up through bonds issued by the provinces of Neuquén and Salta. And, most significantly, his big overweight in Ecuador that might have hit disaster in the December 2008 default was in fact one of Ledward's biggest alpha generators; he had switched into the 2015 US dollar bond, the one obligation on which the Correa administration did not renege.
Also, like the Fidelity/Pyramis strategy, corporate bonds are an important part of the Franklin Templeton portfolio; almost half is in pure corporates and quasi-sovereigns (which can be as little as 50% state-owned). The signs are that Ledward's allocations tend to be a littler racier than Kelly's: the portfolio's volatility is much higher than the benchmark's across all time horizons, and its 8.71% yield-to-maturity is very high. In his top 10 are the widely-held favourites Georgian Railway and Cemex, but the broader portfolio of 13 companies also includes the State Oil Company of Azerbaijan (SOCAR), a Czech coal miner, a Ukrainian iron ore producer, food and retail companies from Brazil, Croatia, Serbia and Bosnia, some state-owned banks and the TV company Central European Media (CME) - a minority-owned subsidiary of Time Warner held in anticipation of a full takeover within the next 12 months.
"We go quite some way down the corporate and quasi-sovereign spectrum," Ledward confirms. "We have an absolute-return approach and aim to generate 8-10% per annum in the medium term, and that's just not possible today in a pure sovereign strategy."
This is clearly not without risk. One of the portfolio's worst positions was a corporate, Brazilian electricity distribution company Celpe, which defaulted in February 2012. Ledward says he put too much faith in the fact that Celpe counts the state-owned Electrobras as a minority shareholder and is majority-owned by a company which itself has minority state involvement.
"It was obvious when I went to Brazil in March that the government was not interested in stepping in and was prepared to see its involvement totally wiped out," Ledward reflects. "It didn't help that the company does not have its equity quoted - if it had, and we'd had the chance to discuss the position with our equity colleagues in Brazil, I'm sure they would have steered us away."
Ledward balances this kind of risk-taking with a combination of unrecognised value and extraordinary seniority in his government portfolio. His top five contains debt from Bosnia and Herzegovina inherited from the former Yugoslavia, which is serviced from a first claim on VAT revenues collected by the indirect tax authority before that money goes to the state. "That's an unusual structure in sovereign debt these days," says Ledward. He has something similar from the two Argentinian provinces, whose bonds are secured on oil royalties paid by oil companies directly to the trustees, which have first claim, ahead of the provincial capitals.
Its value principles are best illustrated by its largest holding, a 3.5 percentage point overweight in an Iraqi bond issued in 2006 in an 80% debt-forgiveness programme. "Iraq got a very good debt-forgiveness deal - way too generous, in fact," says Ledward. "That immediately transformed Iraq into a low-debt borrower with the potential to become a creditor country if oil production increases. However, we think it still offers great value, probably because it doesn't have a credit rating and is not listed in Europe."
Still, the Franklin Templeton strategy is by far the highest-octane of those featured here, especially next to the one managed by Sydinvest, which also happens to be the strategy that relies most explicitly on top-down views. More than 40% of its portfolio is in credits rated at least BBB- and almost 65% is in BB- or better; it does not hold corporates and has long been underweight quasi-sovereigns; outperformance through 2011 was matched by a lag in the Mercer rankings during the rally of Q1 2012.
"We've been moving gradually closer to adding more risk, but we have been running a cautious portfolio, which reflects our view of the macro situation," confirms senior portfolio manager Phillip Blackwood.
Security selection is important to the Sydinvest strategy, but bottom-up, fundamentals-based country selection is the main driver and top-down is an important input. Its biggest country overweight, Russia at six percentage points, illustrates the point well. The main position in the US dollar 2028 bond with a 12.75% coupon is held, counter-intuitively, because it is very high priced. That means a bigger potential loss in the event of default, but also a risk premium that translates into a wider spread than on the rest of the sovereign curve. Blackwood is happy to take that risk in Russia, where he does not expect a default, but goes for the lower dollar-priced bond in, say, Venezuela. That's a security-selection decision that is dependent upon a view of country fundamentals. But behind this is a macro story, too.
"There has been something of an oil theme in our portfolio for some time, which we have played in Russia, Venezuela, Nigeria and other countries," says Blackwood. "At the heart of our process is the fundamental credit analysis - trying to identify improving or deteriorating sovereigns. Our framework is a country-scoring model that helps us keep track of the quantitative factors, while the portfolio managers keep up-to-date with all of the things that can't be modelled. We overlay that with the top-down picture, looking at outside impacts on each country - growth, trade, financial, commodity shocks - and deciding which countries will be affected positively or negatively by those shocks."
None of our featured strategists rely on top-down regional views, and they arrive at portfolio regional weights that are similar in some respects and very different in others.
The Sydinvest team's cautious approach is at least as much about avoiding overbought markets as over-cyclical ones. An off-benchmark AA-rated Qatari bond offers a decent pick-up in spread for its ultra-low credit risk, for example, to balance underweights in benchmark countries like Brazil, Colombia in Latin America, and the Philippines in Asia, where spreads are too tight.
"Brazil, Chile, Colombia, Peru, Panama - they're all good credits and there are no near-term issues at all, but they trade with five-year spreads around 140 basis points and we think that the world is evolving towards pricing the risks a little more sharply," says Blackwood. "We think that these spreads are where they are more because of flows than because of fundamental value."
Latin America is a 16 percentage point underweight for Sydinvest. But the exception is Mexico, the fund's biggest single-issue holding. GMO also has a (smaller) underweight to Latin America. It is overweight Argentina and Venezuela, as we know, but has significant underweights in Brazil, Chile and Colombia; it is now underweight Mexico, too, but until recently had big positions in both the government and Pemex, which it swapped for the 100-year bond issued in 2011 at a discounted price of 91cents.
"Why would Mexico give this value away?" muses Vandersteel. "They probably knew what they were doing, but think of the political context - Europe is cracking and the Mexicans can stand up and say that they can borrow for 100 years. And the coupon was very low, so that looks like a good deal to the Mexican in the street - who has no idea what a great deal it was for lenders."
As one might expect from this statement, GMO is significantly underweight the ‘cracking' markets of Europe. That's one reason Q2 2012 was difficult, when Hungary rallied more than 8% after meeting requirements for EU transfers beginning negotiations for a precautionary loan from the EU, ECB and IMF ‘Troika'. Hungary certainly has some of the ‘basket-case' characteristics that throw up so much opportunity for Vandersteel in Latin America - but while GMO's country analyst has been enthusiastic for some time, she blames a preponderance of European crossover and convergence funds in the region for pushing Hungary's bonds to prices that do not compensate for the political uncertainty.
Sydinvest, which is significantly overweight Europe - particularly Russia - is overweight Hungary.
"We felt that Hungary was getting closer to making some changes to central bank law and that ultimately those reforms will be forced through under pressure from the IMF," says senior portfolio manager Thomas Brund. "We are not super positive on Hungary, and we are very focused at the moment because of the political problems they have internally and with the EU, but we do have a slight tactical overweight because of valuations; and we have a duration underweight - more short-dated than the benchmark."
Europe is also overweight at both Franklin Templeton and Fidelity/Pyramis. At the latter, Kelly is neutral Hungary and agrees with the Sydinvest decision to go shorter-dated there: "The moves they have made to get onside with the IMF and reform central bank law certainly made their bonds money-good for the immediate future, but it's harder to be optimistic with the political backdrop". His bigger overweight is in Ukraine, where he anticipates a resumption of the IMF programme after October's legislative elections and is happy to sit on short-dated US dollar bonds yielding 8-9%. Indeed, the overweight recently reduced as a 2012 bond matured.
There are also differences over Asia, where GMO is essentially neutral - although underweight one of the big names in Indonesia and overweight Pakistan and off-benchmark Korea - and everyone else is underweight. Blackwood at Sydinvest likes Mongolia and Sri Lanka, but Ledward at Franklin Templeton cannot find much good to say about valuations there at all.
"We have trouble filling our 10% limit in Asia," he admits. "Because there is a local bid, Asian bonds always look expensive. We've been looking at some of the corporate credits coming out of the region, but you have to take major care with those - as the Sino-Forest Corporation example illustrated. We have just over 12.5% there, but we really aren't particularly comfortable with some of the positions. We have two state-owned Indian companies, one in oil and one in electricity generation. But we also have a high-yielding corporate in the shape of Vedanta Resources, where at least we feel comfortable that we are being rewarded for the risk. But ‘corporate governance' is a phrase that hasn't been translated into Indonesian yet."
Where everyone does agree on a region, it is Africa. But here, country alpha is everything. GMO and Fidelity/Pyramis both agree on Congo, which is the former portfolio's second-biggest holding, where soon-to-amortise bonds are offering decent value. But GMO's overweight in Gabon has been a drag recently, thanks to a falling oil prices, and Fidelity/Pyramis's local-currency short-dated Ghanaian bonds, yielding 15-16% at three years, haven't quite worked out, either.
"Our thesis was based on what would happen when offshore oil came to West Africa," Kelly explains. "We knew Tullow Oil, so we got good production statistics from that company, and the thesis was that if the current account and trade deficits turned into surpluses from this oil [and] the currency stabilised, that would earn us an outsized returns with an unhedged investment. I think it will still work out, but what has happened is that the Ghanaians are running large budget deficits in anticipation of these revenues, and monetised those deficits via the central bank, leaving the currency weaker than we expected. The euro-zone issues and the slowdown in China has also made the outlook more uncertain for some of these frontier markets."
But neither GMO nor Fidelity/Pyramis took real advantage of one market that has been completely uncorrelated with global macro trends - the Ivory Coast, which rallied some 60% in the first seven months of 2012 alone. This was one high-octane opportunity that the otherwise cautious Sydinvest team exploited to the full with a 2.5 percentage point overweight. The story began back in 2010, when the country was convulsed by post-election violence and edged by the IMF into a default on some coupons, crashing its bonds to 38c on the dollar.
"Some people won't invest in a defaulted bond," says Brund. "But we're not concerned about default We're concerned about default-related losses. We went into Ivory Coast before they defaulted, and even just before they defaulted, when the likelihood of default was very high, we went in more. We were happy to take that default to make sure that we were well-positioned for the upside."
All in all, it is difficult to generalise about the insights underlying the data in this month's Mercer table - and in a way that is the most important point. An asset class that is so often discussed in the context of global macroeconomic rebalancing and wealth-transfer - as a long-term beta play - is in fact a tangle of complex alpha opportunities. And that is true even, indeed especially, for long-term investors.