Emerging market countries represented in the fund include Mexico, Brazil, South Korea, Hungary, New Zealand, Turkey and Portugal. Although these and other developing economies have not been as affected by the financial crisis as the developed world, and their central banks and governments have taken measures to rein in inflation and promote business growth, bond investors have overlooked or punished them. Commodity-linked countries such as Australia and New Zealand are also good plays on an eventual economic recovery in developed markets.
Smith believes emerging markets present a better alternative to U.S. junk bonds for investors seeking higher yields. About a year ago, he sold the fund’s small position in U.S. below-investment-grade corporate debt, which was yielding around 6% at the time, and moved the money into Portuguese bonds with an 11-year maturity that were yielding around 9.5%. “High-yield U.S. bonds are expensive, and they are likely to stay expensive,” he says. “The Portuguese bonds have better risk/reward characteristics, and the country is taking austerity measures to improve its credit profile.”
The fund is most overweight in Mexico; more than 14% of its assets are in Mexican bonds, while the index has less than 1%. Smith likes the country’s healthy 3% to 4.5% GDP growth and the healthy yields of 7% to 7.5% on the sovereign debt.
“The Mexican economy is improving as the government takes a more business-friendly, supply-side approach and moving away from socialistic policies,” he says. “Government officials are also making a greater effort to address corruption.” Recent changes, such as deregulation of the telecommunications industry and efforts to increase oil production, should help boost the economy and expand the country’s growing middle class.
A common and encouraging theme among many emerging market economies, he says, is a move away from “socialistic policies” such as government subsidies or broad labor union concessions toward supply-side policies that encourage business growth and investment. In Ireland, for example, pay cut concessions by public and private workers have helped stabilize the economy. In Brazil, Petrobras has opened up joint venture drilling in the region to foreign companies.
To Smith, business-friendly moves such as these will be instrumental in shifting the economic tide in favor of those countries. At the same time, he criticizes increasing U.S. efforts to prop up the economy through government intervention and regulation as measures that just kick inevitable problems down the road. “Our president feels that liberal spending and a socialistic approach is going to solve our problems,” he says. “I disagree with that viewpoint.” In Europe, “high taxes and unfriendly corporate policies” impose a threat to economic expansion.
Improving credit quality in emerging markets, he says, could be the dark horse that rewards bond investors this year. “In country after country, fiscal issues are being addressed by policies that encourage investment and consumption. That should have a positive impact on developing market bonds and currencies.”