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Emerging Market Debt: The great correlation

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Emerging market debt has been driven by Fed policy more than fundamentals lately. Martin Steward asks managers how portfolio positioning has responded to these unusual markets

This year has been an annus horribilis for emerging market bonds. Poor performance and outflows have been unusually prolonged. Making it worse is the nature of that poor performance: in both currencies and rates, the driving factor has been the response, in US markets, to perceived hawkishness from Federal Reserve chairman Ben Bernanke.

“This sell-off has been different than other recent examples in 2010-12,” notes Marco Ruijer, lead portfolio manager in hard currency emerging market debt at ING Investment Management. “Back then you’d get the index losing 5% or so because of spread widening.
This time around it was all US Treasury-related.”

Tina Vandersteel, portfolio manager at GMO, points to the resulting jump in correlations: “We haven’t seen a quarter when rates and spreads made a big move in the same direction for a while.”

Both observe that, while that left nowhere to hide, hard-currency bonds fared better than local currency in anticipation of dollar strength and, more counter-intuitively, higher-beta, illiquid and idiosyncratic bonds with low sensitivity to US rates were the safest havens.

“[The sell-off] was a combination of spreads being too tight, Fed ‘tapering’, and Treasuries moving dramatically,” says David Robbins, portfolio manager in emerging market strategies at TCW. “At the same time, high-yielding, shorter-duration paper held-in a lot better.”

So how were the strategies under review positioned coming into these peculiar markets? And have they been repositioning for newly-cheap opportunities – or hunkering down?

Unexpected
GMO’s strategy looks for deep-value opportunities that require little forecasting of macro conditions or even fundamental creditworthiness.

“We try to order our bets in descending order of conviction,” explains Vandersteel. “The thing we know the most is that there are only two outcomes for holders of sovereign debt – payment or default. When they pay, you get your principal and your coupons; when they default you generally get around 20 cents on the dollar. Everything else is much less certain.”

So the trick is to find bonds priced at close-to-default levels. That leads GMO’s long-term buy-and-hold strategy into very idiosyncratic, usually illiquid bonds – like Argentina’s post-restructuring eurobonds, which trade in the 30 cents range and represent a six percentage point country overweight.

Getting bonds at that price means that when something unexpected happens, such as a New York court ruling that Argentina has to pay a hedge fund holdout on its dollar bonds, the fundamental value case for holding those bonds is unaffected. The same applies to loose talk from developed-world central bankers.

“If you own something priced very close to default value, you sit back and wait to see how it all unfolds,” says Vandersteel. “The big story in Q2 was the huge rise in US interest rates: countries that aren’t particularly interest-rate sensitive – like Argentina, a binary default-or-not case – did better.”

As she concedes, few cases offer that kind of slam-dunk, but she does argue that focusing on idiosyncratic security-selection, rather than country risk, inevitably draws you into the strange-looking yield curves built by governments that are non-economic actors in their own debt markets, like Argentina and Venezuela (GMO’s third-biggest country overweight), rather than, say, Brazil or Mexico.

Consistency
At Logan Circle Partners, head of emerging market debt Scott Moses emphasises his strategy’s flexibility to allocate between hard and local-currency sovereigns and corporates. During the turmoil of autumn 2011, for example, local currency was taken down to around 10% from its usual 30% or so. Today, local currency is at around 25% of the portfolio and declining, with US dollar corporates at 33% and quasi-sovereigns at 8% – tilts that ought to have benefited relative performance through Q2 as currencies sold off along with low-beta, duration-sensitive names.

Like Vandersteel, Moses makes the point that fundamentals-based security selection leads to more idiosyncratic positions, a tendency to get extra yield from illiquidity rather than excess credit risk, and generally a clearer understanding of the type of risk one is taking.
Unlike the strategists at GMO, Logan Circle adopts a more explicit portfolio-balancing approach, attempting to barbell its key corporate-bond alpha positions with more US Treasury-sensitive exposures. That worked well in 2011, but less well over recent months.

“During Q2, the portfolio was more conservatively-positioned than it has been on some occasions in the past – but it certainly didn’t react in the way we anticipated because of the Treasury sell-off,” Moses concedes. “Our local rates exposure exhibited much higher price sensitivity to higher US interest rates than we anticipated. If you build a portfolio to offset risks, it’s difficult when correlations trend to the same level.”

Still, there are reasons why this strategy is the most consistent among those featured, and there is no doubt that it has been better positioned than portfolios tilted towards local currencies and big-name sovereigns.

Conservative
ING’s hard-currency debt strategy benefited from its lack of local-currency exposure, of course, but in other respects its balanced portfolio, with tilts towards corporates and high-beta, shares characteristics with Logan Circle’s.

Newly installed in March 2013 after a personnel shake-up at ING, Ruijer is introducing a few changes to the basic philosophy, one of which is to try and achieve a better risk balance across the portfolio by classifying positions according to their level of beta, a telling metric through the recent turmoil.

Ruijer had, in fact, been reducing risk since he came onboard but remains aggressively-positioned relative to the benchmark. Regionally, the portfolio is happy to go for yield, overweighting EMEA and underweighting Asia and Latin America, the latter by almost nine percentage points.

“The impact of the back-up in Treasury yields in Q2 was seen especially in the low-beta Latin American names, some of which are trading at just 100 basis points over US Treasuries,” Ruijer notes. “That spread simply can’t absorb a 100 basis point move in the US Treasuries, whereas the high-beta bonds have much lower correlation with Treasuries because they have more of a spread cushion.”

Where Ruijer does hold Latin America, it is Argentina and Venezuela again – the latter is the biggest country overweight. “It’s almost irrelevant what US Treasuries are doing, because they trade more on price,” he says.

Corporate bonds account for around 13% of the portfolio, and while that is close to the strategy’s 15% limit, Ruijer has been dialling back on what is, in any case, a fairly conservative allocation. “In principle we have senior unsecured bonds issued by the major companies within our universe, mostly quasi-sovereigns in the utility, banking and oil & gas sectors,” he explains.

This relatively modest, low-beta corporates exposure may be why ING failed to keep pace with either Logan Circle or TCW in the opening shots of 2013.

Deep value
TCW can boast similar consistency to Logan Circle’s, and Robbins likewise talks up the flexibility to ‘cherry-pick’ from the three main markets. But TCW is always more aggressively tilted towards corporates (ranging from one-third up to two-thirds of the portfolio) and hard currency (between two-thirds and 100%). Right now the strategy has 50% in corporates – 60%-plus, including quasi-sovereigns – and 80% in the US dollar.
Co-portfolio manager Penelope Foley points out that TCW began investing in a bottom-up research team dedicated to corporate credit as long ago as the late 90s.

“Most of our competitors didn’t dedicate significant resources to corporate credit research until there was a benchmark,” she says, referring to the CEMBI, launched by JPMorgan in 2007. “Even then, many remained focused on tracking error against a sovereign index, and only used small allocations to quasi-sovereign corporates to spice up the yield a bit.”

TCW’s appetite for corporate credit can be expressed in short-term value positions when the opportunities arise, sometimes in pretty big bets: some 10% of the portfolio went into Chinese real estate issuers in late 2011, for example, when TCW rode yields from the mid-to-high teens down to single digits over the course of 12-18 months.

“Not all the corporate opportunities come out of major sell-offs like that, but they do exemplify the fundamentals-based, bottom-up research behind our approach, which is not only about looking at where the bonds are trading relative to their current debt metrics but also looking forward to the potential for deleveraging over a reasonable holding period,” says Foley. And what is a “reasonable” holding period? TCW works to 6-12 month IRR targets – this is a very different approach to value than GMO’s.

But while TCW certainly prefers corporates to sovereigns and the US dollar to local currencies right now, its positioning seems more conservative than it could be. The biggest country overweight, for example, is Russia at almost 10 percentage points. Despite concerns about governance, Foley and Robbins point to its solid sovereign balance sheet and favour good-value quasi-sovereigns.

“Names like Sberbank and Gazprom are still some of the cheapest BBBs out there, and we don’t lie awake at night worrying about their ability to access financing,” says Robbins.
“If 2008 taught us anything, it’s that the quasi-sovereigns that are very close to the government always have liquidity available to them.”

Following the “indiscriminate” sell-off of autumn 2011, TCW took portfolio credit quality aggressively down to mid-BB. Foley and Robbins are not yet prepared to do the same thing today, settling into strong BBs and weak BBBs.

“That reflects the fact that we are still in a volatile market environment, albeit with significantly more attractive spreads than was the case at the beginning of this year,” says Foley.

Inflection
One portfolio that has been positioned aggressively is Aegon USA Investment Management’s  Global Diversified. This is essentially a US dollar sovereign strategy but its big tilt towards sub-investment grade countries and longer duration made Q1 2013 a major struggle. At that point, the strategists maintained that “abundant liquidity, portfolio allocations into the asset class, and normalising growth should be supportive”.

Speaking with lead portfolio manager Sarvjeev Sidhu in August, however, it is clear that perceptions have turned almost 180 degrees.

“There was a bit of a misread of the market by us as we came off of a very strong 2012,” he admits. “The sharp movement in rates would usually be offset by spread tightening, but that didn’t happen through Q1 and we suffered negative performance.”

Not long ago, he expected to greet any sell-off by loading up on more risk, as he did after 2008-09. “Now, this year feels very different,” he says. “I believe we are in the midst of a real paradigm shift, and we have gone very defensive, holding higher levels of cash and shortening duration.”

He outlines three main pillars of his strategy’s philosophy. First, active management can pay off in debt markets. Second, emerging markets are “financially integrated” with the rest of the world. And third, business cycles are less important than political cycles.

“The consequence of that is managing portfolios around key inflection points,” he adds.
“While there have been few of those, I think that the recent announcement by Ben Bernanke in May could well be one for our markets.”

Extraordinary monetary policy has become ineffective, he argues, leading us into a period of asset deflation and markets forcing rates higher. Slower growth, higher yields, more severe outflows and weaker currencies will be the result in emerging markets. Investors should be defensive, and build positions opportunistically in strong countries.

“If governments have taken advantage of the last few years to implement good structural reforms and monetary and fiscal policies they will be able to weather the storm ahead of us,” he says. “Growth in the US is not helping China. Instead we are overweight Latin America, and within that Mexico, Peru, Colombia – countries that are part of the free-trade agreement and can benefit from US recovery. Russia we remain overweight, because they have a good fundamental credit position and a lot of foreign currency reserves – and that’s mostly the quasi-sovereigns.”

Sidhu thinks that the ratings momentum in emerging markets is about to reverse, particularly among those corporates that have issued significant US dollar debt. “We think that the oxygen is slowly starting to run out and we expect to see some compelling value over the coming years among those companies that have foreign currency earnings,” he says.

While he expresses a familiar view about idiosyncratic credits that are insulated from the macro noise by hanging onto names like Ukraine, Argentina and Venezuela to maintain some yield, the overall message is very clear.

“When you ask investors what’s on their mind they say they are very bearish, but they are positioned as if they are still bullish,” he notes. “We are prepared to sacrifice some performance if markets do rally in the short-term.”

Stuck
As he suggests, his newly bearish view is not the consensus. That would point out that emerging markets today have greater policy flexibility thanks to modest debts, handsome foreign exchange reserves and much lower US dollar exposure. The risk of currencies being made to take the strain of slowing growth is real, but compensated for by higher yields than those available from comparably safe developed-world issuers. From this perspective, technical weakness offers an opportunity to buy into fundamental strength. Do our featured managers agree?

“We hesitate to be one of those managers saying ‘this asset class is really strong now because reserves are so healthy’,” says Vandersteel at GMO. “The spreads for most of the major countries accurately reflect fundamentals. Where they don’t – Argentina, Venezuela, Ukraine, Egypt – we have to make an additional judgement about whatever else is going
on.”

While local-currency sovereigns took the biggest hit during Q2 2013, Moses at Logan Circle still prefers corporates and dollar sovereigns for now, harvesting income from what he describes as “anchor ideas” in fundamentally stable companies like a Russian telecoms issuer yielding 7% or a de-leveraging Brazilian beef industry firm that still yields 10%. This is where he wants to be “if we are stuck in the kind of environment we have today”.

ING is “moderately constructive”. Ruijer does argue that emerging markets are fiscally healthier today – but, like Vandersteel, urges caution now that prices have come back a bit, to what he regards as close to fair value. Still, he likes a de-leveraging story like Hungary’s and a good frontier story like Rwanda’s.  

But probably the most active traders in this sample – TCW, with its 6-18 month horizons and 125-150% annual turnover – have notably declined to make any big moves, back into local-currency debt, for example.

“When we think currencies have found their level and we get some stability in US rates, then we think that local-currency bonds may be more interesting,” says Robbins.

That day isn’t here yet. Will we get there via a grinding period of volatility such as that anticipated by Moses; or the violent inflexion envisaged by Sidhu? Either way, these markets will be dominated by what happens to US Treasuries and the US dollar: investors will need to balance between fundamental issuer strength and technical ‘shelters’ from the macro storm, such as highly idiosyncratic risk or illiquidity. It feels like we have seen the beginning of a very interesting time for emerging market debt.

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