Five years on
When Peter Wilby begins our conversation by remarking on Stone Harbor Investment Partners' imminent fifth birthday, it is as if, stepping back, he suddenly realises what a thrill ride it has been.
"Who could have imagined what was to happen?" he laughs. "There can't be many asset managers that went from $8bn to $30bn in that time - much less a credit shop in the middle of the worst credit crisis ever seen."
Then again, that $8bn beginning was pretty auspicious. When CIO Wilby and 55 ex-Salomon and Citigroup colleagues struck out independently in 2006, all but one of the clients they were allowed to solicit came with them. More money quickly arrived from investors who liked the alignment of a 100% employee-owned boutique. Stone Harbor launched with 32 institutional clients, 75% of its AUM coming from the US.
Today it has 35 institutional clients in the UK alone. Heavyweight European clients include the Berkshire, Clwyd and Barclays pension funds in the UK, ATP in Denmark and VER in Finland - and that is while the furnishings still gleam in a new London office that replaces the modest ‘shop front' opened in 2006.
Stone Harbor hopes to capitalise on a revolution in pension funds' attitude to credit in a low-but-rising yield environment. Paul Timlin, who runs international client management, notes that Swiss institutions that typically regarded equities as the only place to take risk now look more seriously at credit; and German investors are also picking up manager searches in high yield and emerging market debt. With developed-world government balance sheets groaning and yields bottoming out, as Timlin puts it: "We are seeing a recognition that today the greatest risk might be not taking risk."
Emerging markets have been a favoured place to take that risk as institutions have been encouraged by their fiscal discipline. More recently, a combination of inflation and political upheaval in the MENA region has led to some re-assessment. I remind Wilby of the first chapter in Carmen Reinhart and Kenneth Rogoff's ‘This Time is Different', which recalls that the emerging economies were also in favour during the 1920s, as developed economies struggled under First World War debts - before reality struck in the shape of the Great Depression.
"I would say this time is different for emerging markets - but I do have to qualify that," Wilby replies. Far from depression, this time the key risk is imported price inflation - and that's natural for fast-growing, commodity-hungry economies, he says. He does not anticipate large liquidity withdrawals: institutions are strategic and even as retail money was leaving, Stone Harbor itself managed to raise $382m for its closed-ended Emerging Markets High Income fund.
"We're seeing fiscal discipline alongside technical quality at central banks," Wilby says. "The basic western financial model overlaid on better-managed economies now seems to be unstoppable. That's not to say that you can give free money away - there are a lot of people who will take it, whether that's a government or a corporate in Brazil, Thailand, the US or Canada - but a return to the first world-third world dichotomy is unthinkable now."
Stone Harbor's bottom-up fundamentals focus makes country selection its key driver of risk in emerging markets. "We are quite tactical in our trading and allocation style, but there are certainly high-momentum countries and opportunities around the ongoing European credit reflation problems that we may miss, for example," says Wilby. "But that is also why we don't get clipped at the end of the cycle owning a lot of easy-money issues." Over the past six years its composite emerging markets portfolio has delivered 2.43% annualised outperformance.
But the emerging debt markets are changing. As discipline becomes the norm, country-specific credit risk is likely to diminish, overtaken by local currency appreciation as growth differentials play out. Stone Harbor's core Emerging Market Debt portfolio can invest tactically in local currency debt, but the firm also manages a dedicated local currency strategy, while its Emerging Markets Debt Global Allocation strategy allocates tactically between hard and local-currency portfolios. Corporates are likely to become greater sources of opportunity but, as Wilby observes, their ability to come to capital markets is a result of increasing sovereign credibility.
"We've done emerging corporates for 18 years, but it's always been tactical," says Wilby. "They always offered diversifying risk, but so often they have been swept up in country-specific issues, including huge balance-of-payments crises."
In the era of dollar-pegging and hard-currency debt, currency market shocks could result in huge financing-book mismatches that turn strong companies into shaky credits overnight. When a sovereign like Brazil sets out to finance itself 80% in local currency, it deepens domestic demand for corporate issuance, too. "More matched-up financing should lead to more company-specific drivers of risk," Wilby argues.
To reflect the growing importance of emerging corporates, Stone Harbor has hired ex-Deutsche Bank prop trader Chris Wilder for the London office, plus two emerging market analysts. London will also see an expansion of high yield corporate and sovereign specialists later this year, as the firm works to get closer to fast-growing European markets. Wilby expects Basel III to send a lot of borrowers to the bond markets and Stone Harbor is developing a standalone European high-yield strategy to exploit that environment.
The growing European universe, as well as a broadening into fixed income value, loans and convertibles, has enabled the firm to double its AUM in the high-yield complex since 2006 while preserving a conservative philosophy that outperformed its benchmark by 451bps in 2008. The one less successful part of the portfolio - high-quality bank loans hit by the liquidity panic - ended as one of the better-performing parts of the portfolio during the recovery, which otherwise left Stone Harbor behind somewhat: it lagged its benchmark by 10.58% in 2009.
"It was hard to rotate into something more aggressive," Wilby concedes. "But our investors aren't looking for twice the level of market risk."
Fair enough. Thanks to 2009, unless you have been invested for at least six years, Stone Harbor's cumulative annualised return in high yield lags its benchmark, But over 10 years you'd have picked up 63bps of annualised outperformance - with 2.05% less annualised volatility.
One intriguing side-effect of Stone Harbor's conservative value approach to high yield is the diversification it delivers against emerging markets. As Wilby explains, companies will usually maintain the debt they need to deliver a target return-on-equity, rather than pay it down. Governments, by contrast, constantly have to return to the bond markets and, therefore, de-lever to keep down costs. "A company can be perfectly happy to be B+ forever, but every government tries to improve its credit rating." As a result, against the value bias in high yield, even a value-tilted emerging markets portfolio will exhibit a certain growth bias. "Our emerging markets is a very good recovery style while our high yield is very good end-of-cycle," says Wilby. "That tends to result in inversely-correlated alphas."
Stone Harbor offers strategies that exploit this. Its two Global High Yield portfolios treat emerging market debt as a kind of growth-biased high yield, allocating tactically between this and the developed corporate markets (one has a strategic split of 50-50, the other, 70% high yield and 30% emerging markets).
It is towards multi-strategy portfolios that the firm sees institutional investors turning now, as they become more focused on relative valuations. It all plays into the broader institutional re-assessment of yield-enhancing credit, and should translate into growth for Stone Harbor's core fixed-income strategies which allocate between high yield, non-US investment grade and emerging markets.
But, as these offerings make clear, high yield and emerging markets have become strategic institutional assets now, and there is still a long way to go before that portfolio rebalancing has run its course. "Worldwide we're seeing a diversification out of developed markets," says Wilby, "and our investors were net adders of credit risk through the crisis. They will make tactical adjustments, but the longer-term strategy is clear."