Investor concern about the U.S.
economy casts a long shadow.
By Alan Lavine
Will emerging market bonds become the next beleaguered asset class?
If they do, it's as likely that the cause will exogenous events, not internal problems. "Interest rates and inflation news in the U.S. started the correction in emerging market bonds," says Arijit Dutta, emerging market analyst for Morningstar Inc. in Chicago. "The spreads on bonds are starting to widen as money has flowed out of the funds."
Because most emerging market bonds are dollar-denominated, they typically track interest rates and bond prices in the United States. In addition, emerging market bonds also are trading in line with commodity-based economies.
But has the balloon burst on emerging market bond funds, which returned double-digit rates over the past three years ending in 2005?
At mid-year 2006, the funds gave back their first-quarter gains of about 5% and were down -2%. Most of that decline came in late May and June, when the market sold off due to concerns about rising interest rates worldwide. Investors pulled $400 million out of emerging market bond funds, or 1% of assets, according to Emerging Portfolio Fund Research of Cambridge, Mass.
Dutta characterizes the sell-off as profit taking due to concerns about central banks raising interest rates. Nevertheless, bond credit quality, on average, is healthy, he believes. "The credit quality remains strong. There is a foreign exchange surplus, and emerging market countries have sufficient revenue to service their debt."
Emerging market bond-fund performance was hurt this year by extra foreign currency risks as well as riskier investments. In previous years, efforts to reach for higher yields led to investments in Serbia, Lebanon, Croatia, Ecuador, Iraq and the Philippines. This year, however, weaker credits have come under pressure and sustained losses, Dutta says.
Both the global equity and bond markets have been on the decline despite a strong global economy. U.S. Treasury Undersecretary Timothy Adams, says in a recently published report that the world economy is in transition, moving from mild economic conditions and high liquidity to conditions in which central banks are draining liquidity out of the system.
Nevertheless, he says, economic fundamentals are good. Central banks are raising interest rates to prevent their economies from overheating. Such action should result in steady growth and prevent runaway inflation.
In addition, the International Monetary Fund's 2006 World Economic Outlook projects that Latin American and South American economies should grow, on average, at 4% annually next year. The forecast for Emerging Europe's economic growth next year is 5%. And the Commonwealth of Independent States, which includes Russia, Ukraine and Armenia, is expected to grow at 11% next year (see Table 1).
"Global financial market conditions remain very favorable," the report says. Buoyant capital inflows to emerging markets, it adds, have allowed many countries to prefinance 2006 borrowing needs.
But a number of risks could derail emerging market bond and stock markets, it warns. Risks include:
High and volatile oil prices.
A tightening in financial market conditions.
Rising global imbalances.
An avian flu pandemic.
Meeting the challenge of making rapid progress in addressing global imbalances. The United States needs to reduce its budget deficit and increase private savings. China and other countries must boost domestic demand and develop exchange rate flexibility.
Emerging market bond fund managers say the declines in 2006 are due in part to a decline in foreign currency values against the dollar and a correction after several years of double-digit gains. But longer term, the emerging market economic fundamentals look good.
"We see the recent volatility as a healthy correction in global markets-specifically a reduction in crowded trades (emerging equities in particular)," says Mike Conelius, manager of the T. Rowe Price Emerging Market Bond Fund. "Unlike past crises, the current sell-off is not due to fundamentals but mainly position reductions. The fundamentals in emerging sovereigns are indeed quite sound."
Conelius says that the widening of emerging market yield spreads is creating buying opportunities. But one of the biggest dangers comes from weaker exchange rates.
"One downside from weaker exchange rates is the potential inflationary pressures, particularly in countries still establishing credible inflation target regimes, (like) Brazil and Turkey," he says. "This risk is joined by global inflationary concerns."
He also says that investors should note that if interest rates rise significantly from current levels, the share price of his fund will decline. That's because the fund takes a high-risk approach to income investing.
His fund has 35% of assets in Brazil, although he had cut back on his positions. He also has a large stake in government bonds issued by Jamaica, Argentina and Indonesia. Last year, for example, he invested in countries like Serbia and Lebanon. Earlier this year, he bought Iraqi bonds, which pay among the highest yields in dollar-denominated debt. his reasons revolved around debt relief-the amount of foreign currency going into the country-and the expectation that Iraq's bonds should perform well when oil production recovers and the country emerges from the war.
Michael Gomez, manager of the PIMCO Emerging Markets Bond Fund, says he's taking a conservative approach. He selects bonds based on a top-down approach to investing that includes a three-to-five-year outlook for the global economy and interest rates. Then he looks at duration, the yield curve sector weights and credit quality. The average credit quality of bonds in the portfolio is A.
The fund's largest holdings include bonds issued by higher-rated countries with solid fundamentals, such as Mexico, South Africa, Russia and Tunisia. He's also accumulating bonds in countries with improving fundamentals, such as Brazil, Ukraine and Ecuador. But he is avoiding weak credits, like the Philippines.
"Given the potential for near-term volatility in spreads, we have positioned our portfolios more defensively, including increased cash positions and a reduction in our credit spreads," he says. "We continue to add value by substituting quasisovereign for sovereign issuers and credit default swaps for physical securities."
He expects to buy corporate bonds as more companies issue debt. "We will look for opportunities to increase our exposure to corporate securities where the risk/return profile is attractive."
The greatest risks: Continued improvement in European economies and the outcome of elections in Latin America over the next 12 to 18 months. Unfavorable political developments resulting in imprudent social and economic policies is a danger he is keeping close tabs on.
Bill Nemerever, co-manager of the GMO Emerging Country Debt Fund, also is taking steps to limit risk while striving to outperform the JP Morgan Emerging Markets Bond Index. He takes advantage of inefficiencies in pricing of emerging market government bonds and bank notes.
"We've made no real changes in the fund as a result of the bond market pullback," he says. "The fund is fully invested. Our style is to look for undervalued debt. We are avoiding the high-end debt of China, Chile and Columbia and overweighting in the Ukraine and Uruguay.
Rising interest rates pose a risk to the fund.
Overall, he says the fund is well diversified. It invests in more than 35 countries, so it avoids single-country risk. He attempts to limit default risk in some countries by entering into credit default swaps. He is investing in credit default swaps in Russia, Brazil and Mexico due to cheap swap prices.
Nemerever typically has at least 75% of assets in dollar-denominated debt or debt hedged in U.S. dollars. He often gets exposure to these investments through investments in synthetic bonds, which combine futures and fixed-income securities, as well as direct investments in fixed-income securities. In addition, he invests in shares of the GMO Short Duration Collateral Fund. This is an in-house fund that is only available to GMO's investors. The fund owns high-quality, low-volatility, asset-backed securities issued by private and government issuers.
The fund has 5% of assets in the GMO Short Duration collateral fund. Nearly two-thirds of the fund's assets are invested in Mexico and Brazil. Other large holdings are in Russia, Venezuela and Turkey.