Bonds are back in favor among issuers and investors. In April, cash flows to emerging debt markets picked up, bringing the year-to-date investment before tax day to some $12 billion, according to Morgan Stanley, owner of MSCI, owner of the most widely benchmarked EM bond indexes. More recently, inflows to high-yield bond funds broke records at the end of October for the second consecutive week when $4.7 billion poured in following $3 billion the previous week, according to EPFR, a Cambridge, Mass.-based provider of fund flow and allocation data. EPFR attributed the increase to U.S. third-quarter growth numbers and positive news on the euro zone debt crisis.
"The conditions are ripe for high-yield bonds," says Jeff Tjornehoj, a senior research analyst for Lipper, a supplier of mutual fund data and analytical tools. He notes that investors seem to have moved from wanting to preserve their wealth at any cost to seeking growth somewhere. "The summer saw a lot of issuance in the high-yield market dry up," he says, possibly because corporate treasurers saw corporate bond yield spreads start to widen, which would reflect some perceptions of risk. But the spigot opened up more recently. "It's benefited the broad continuum of bond funds. High-yield funds placate investors while they're waiting for equities to give them their 8% or 10% annual returns again."
Judging by the three-year averages of top-performing bond funds on Morningstar as of October 25, those goals aren't out of reach. But they aren't risk-free, either. The Delaware Extended Duration Bond A Fund, a long-term bond fund benchmarked to the Barclays Capital Long U.S. Corporate Index, headed the list with an 8.54% one-year return and a 24.22% three-year gain. Unlike expense ratios of the past that reflected high transaction and custodial fees, today's hot bond funds can keep costs down, and Delaware, for one, has a 95 basis point expense ratio. Tjornehoj calls the fund a "phenomenal performer without taking ungodly risks." The fund, he notes, changed managers in 2007 and has been on a tear since the end of 2008.
Thomas H. Chow, a manager of the Delaware fund, says the success is due to simple shoe leather-good old-fashioned company research on the ground. The fund is 80% invested in corporate bonds from three sectors: financials, industrials and major utilities. For the most part, says Chow, 75% or more are U.S. domiciled companies and the non-U.S. names are S&P 500 types-large caps, etc.
Delaware has built its own risk management system, called YieldCalc, to maintain and monitor its client accounts in real time. Clients can view daily fund performance using a custom overlay reflecting their own instructions to confirm that only those investments they've authorized for their portfolio are purchased on their behalf. Changes can be made to accounts within 48 hours using the system, says Chow.
Another key to the fund's success is understanding the over-the-counter market, he says, since bonds are still largely traded off the exchange. This makes personal relationships important for understanding market biases as it becomes necessary to exit or increase inventory levels over time.
"Their strategy may be difficult for others to replicate when it works extremely well," adds Tjornehoj. The fund's turnover rate of its largely eight-to-ten-year duration bonds is 150% or more a year, meaning its corporate holdings change about every nine months, which is normal, he says. "If interest rates start to move higher, that could be very dangerous for this strategy," he says, though it's a fact true of most bond funds. "If rates go up, these guys will be first to feel the crushing blow."
Along with excessive fees another past deterrent to EM investing has been government volatility. Surprisingly, the debt of Mexico, a country whose lurid depictions of murderous drug lords are seared in memory, affords investors a very high level of comfort at the moment, according to Roberto Sanchez-Dahl, the co-manager of the Federated Emerging Market Debt A Fund, which had a 1.24% one-year return and 22.66% over three years. The fund, which is split 70% into government debt and 30% into corporate debt, is heavily weighted in Latin America (44%), but is also diversified in Europe, Russia and Asia. The Federated fund will buy a credit default swap on a specific country or a swap on a broad CDS index, in addition to futures on U.S. Treasurys. That helps it dampen another problem with emerging markets: low market liquidity.
"Mexico is almost the highest rated in the asset class," says Sanchez-Dahl. He concedes that "the needs of society are great-education, infrastructure, safety-but the economic profile has improved significantly."
Jim Carlen, a portfolio manager for the Columbia Emerging Markets Bond A Fund, agrees. Carlen, formerly an international economist for the U.S. Treasury Department, worked on the Mexico Task Force and in the office of the former Soviet Union. In the early '90s, the concern was stabilizing the peso. But things have changed. "Mexico almost sets the gold standard now in the quality of its policymakers and quality of people working there," says Carlen, whose fund returned 1.55% for the past year and 21.97% for the past three years. "It's a dramatically different country. If you happen to get close to [the violence], it's probably very bad-a disruption to everyday lives and tragic. But you shouldn't mix up pockets of drug violence with the country's brighter economic story."
What Sanchez-Dahl and Carlen do worry about is global volatility: Will the U.S. solve its debt crisis? Will China slow down? How will Greece and Italy be stabilized? What's the U.S. super committee on debt going to come up with? "These effects are much more difficult to map out and predict," says Carlen. "The world is getting more dangerous. In the old days, the IMF would ride to the rescue. Now rescuers are in need of being rescued. Who rescues them?"
Money managers express concern about global links. "The biggest issue in high income yield global markets isn't individual bonds, but the overall risk appetite in the market," says Paul J. DeNoon, co-manager, along with Gershon Distenfeld, of the AllianceBernstein High Income A Fund. This multi-sector portfolio suffered a setback of -0.14% in its most recent annual performance, but it has a 22.25% three-year return. "We're seeing, this year, elevated amounts of correlation between sectors and within sectors of all types of securities, which has to do more with overall risk budgeting than individual sector selection," says DeNoon. "Our job is to focus on individual sectors and building longer term portfolios."
DeNoon doesn't always believe that a rating gives a clear picture of an instrument's risk or potential return. The fund reduced its commercial mortgage-backed securities from the 7% to 8% range to 4% of the portfolio when they were still "AAA" rated. Distenfeld draws from his background in derivatives in managing risk and liquidity by using options on single-name instruments and index CDS, says DeNoon. "We try to keep it pretty transparent to look at."
The multi-sector style is the most interesting part, he says, because managers aren't forced to buy bonds in a sector that isn't doing well just to conform to the style. "Where there's a lot of demand for narrow, focused investment, supply can be of lesser quality than what investors thought they were getting," says DeNoon. "When demand creates supply is when you create a crisis in the credit markets."
The global debt picture last summer weighed on John Carlson, a veteran among EM portfolio managers. Carlson is the sole manager of Fidelity's New Markets Income Fund, which had returns of 1.81% for the year and 20.96% for the past three years, and the Fidelity Advisor Emerging Markets Inc. T Fund, whose returns were 1.37% and 20.65% for those periods. He is now invested 90% in sovereign or quasi-sovereign debt across 50 countries.
He got out of local currency and corporate bonds at the beginning of the summer because he worried that the euro crisis had made the U.S. dollar very cheap-within 5% to 7% of its all-time low-and he predicted a possible 20% sell-off of EM corporates by the latter part of summer. By August, the Mexican peso moved from 11 to 14 and Brazil's real jumped from 175 to 190, which prompted a big sell-off.
Carlson attributes some of his return to the funds' combination of both equities and bonds, a strategy based on original research he conducted with his colleagues, the results of which were published in the Journal of Portfolio Management in the spring of 1998 ("The Relationship Between Bonds and Stocks in Emerging Countries.") They found that as a sovereign's credit quality improves, the relative profile of debt and equity begins to change. Carlson will manage a new balanced fund with 60% EM equity and 40% EM debt that Fidelity has scheduled to release in the first week of November, which will take Carlson's theory to the next level.