Feb 5 2014, 3:48pm CST | by Forbes
Fund managers love emerging market debt for its yield. Where else can investors own a bond paying 10.5%?
But investment companies and financial advisors have a lot of work to do if they are to convince retail investors to return to the world of foreign currency debt.
That’s because bond fund managers had a tough 2013. Rising interest rates caused a capital gain loss in bond funds. When interest rates rise, bond prices decline. And when bond prices decline, active traded funds in particular tend to dump those bonds to buy higher yielding debt, often locking in losses.
Then there was currency depreciation. Investors holding Turkish bonds priced in the local currency saw the Turkish Lira lose 28% of its value against the dollar over the last 12 months. All things being equal, currency can eat into a bond’s capital gains and eat up coupon payments from interest rates. If an investor buys a Turkish bond for 1,000 Lira with Lira exchange being two to one, that means investors paid just $500 for it. But when they go to sell that same 1,000 Lira bond and the exchange is 3 to 1, that bond is now worth around $200 less.
Investors, you’ve been warned.
Bryan Carter, portfolio manager for an emerging market bond fund run by the Boston-based Acadian Asset Management firm, is scouring the emerging market universe for mis-priced bonds; something that has taken a beating but has the cash to save it from a default.
“As a fund, we take a systematic approach to screening for pricing. I wouldn’t call us a value manager because there are non-value parts to this approach,” Carter says from his office on Franklin Street in Boston. To diversify risk in the fund, they do what all bond funds do: buy a mix of local and hard currency bonds, both government, corporate and the quasi sovereigns like state owned companies. To add some “umph” to the fund, they even go down the investment grade scale and into frontier markets. Yes, Uganda is a buy.
How Low Can It Go?
Investors are risk averse to emerging anything right now. With the Fed talking about tapering its massive bond buying program, investors are waiting to see which major emerging market will hit a wall. Turkey? China? Until the dust settles, emerging markets may be out of favor this year as they were for much of 2013.
A look at the performance of key mutual funds is enough to show what’s happened to money put to work here.
The Oppenheimer Emerging Markets Bond Fund fell 19.98% over the last 12 months, eating all of its yield gains. J.P. Morgan and Goldman Sachs’ emerging market bond fund are down a little over 11% over the same period. Acadian’s Emerging Market Debt Fund (AEMDX) — which is only available for institutional investors — is down 18.31% over the last 12 months after declining around 13% in 2013 and rising around 5% in 2012.
“These bonds have been hit hard, but we are seeing a lot of opportunities,” Carter says.
Carter joined Acadian in April 2007 to spear head their emerging market strategy. Prior to Acadian, he was an economist at T. Rowe Price and earlier than that, spent time at the U.S. Treasury Department. He is a CFA and a graduate of Georgetown and Harvard’s Kennedy School, which by Boston standards automatically makes him a globe trotter. No surprise that he is a member of the Boston Council on Foreign Relations.
Here are some of his favorite places on the map.
The securities market in Indonesia is liquid and mostly owned by foreigners. Once the darling of emerging market equity investors, Indonesia was a big underperformer last year. Bond holders saw yields rise to 10%. The rupiah took a hit. It was a mess.
“The good news is that they have a strong economy and their weakened currency is good for exports,” Carter speculates. “We’re overweight Indonesia now and have a full basket of them,” he says rattling off maturity dates all along the curve right on out to a 30 year sovereign bond. Their 10 year bond was yielding 9.08% on Feb. 5.
The rupiah is gaining some muscle. And in the last quarter of 2013, Indonesian GDP advanced at a faster-than-expected 5.72% over a year earlier, up from 5.62% in the previous quarter and breaking a two-year trend of declining GDP.
Indonesia’s five year rupiah bonds pay 8% and two year debt has a yield to date of 7.5%. The rupiah is actually more stable against the dollar than the Brazilian real, for instance. The rupiah is down just 0.3% to the dollar year-to-date, but over a one year period has been clobbered, declining 25% to the dollar.
Acadian’s EM bond fund is overweight Brazil’s local currency debt. Interest rates will be rising shortly, so current bond holders will lose value. Investors need to be mindful of the local currency, which is seen weakening a bit more between now and November, when Brazilians go to the polls.
“The bet we’re making on Brazil is that they’ll be able to cut rates sooner rather than later, so if we are holding those higher yielding bonds we will see demand for them in the market and make a nice capital gain on them,” he says. ”We are positioned at the long end of the curve.”
Brazil’s 10 year bond is currently trading at 13% yield to date and Acadian is overweight.
Another overweight, Carter likens Colombia to Indonesia. Bonds became too hot in a yield-hungry market last year and took a hit. They sold off. Plus, Colombia is not a very well known market. Risk aversion weighs heavy when the mood strikes. Still, it’s a high growth country no longer fighting an economy-busting drug war with the FARC. “They have very good governance too on both the fiscal and monetary side,” says Carter.
Inside Colombia, he likes the corporate bond market and a smattering of government bonds. Bogota Telecom is one. He has the 2023 bonds which yield 10%.
In Russia, Carter likes RusHydro, a state-owned hydroelectric power company. “There’s no risk of this company falling out of favor with the government, or defaulting on its debt,” he says. It’s one notch below investment grade, but a ruble priced RusHydro 2015 pays 7.87% in two coupon payments annually. Russia is also an overweight.
“We don’t see Russia going the way of Turkey and having a currency crisis,” Carter says. ”Russia has tons of foreign currency reserves and they have more orthodoxed central bank management than Turkey. It is a very conservative government and we like that about them.” Russia has $502 billion in cash reserves, according to the International Monetary Fund.
Turkey is like Brazil, further out the yield curve is where it’s at. The only problem is, Carter thinks Turkey won’t be cutting interest rates as fast as Brazil does so coupon payments will be eaten up by capital losses for now. ”We’re underweight or neutral Turkey because of that and have been moving out of longer dated bonds,” he says. Turkey’s 10 year bonds yield 10.01% currently.
The frontier markets are like the emerging markets circa 1950. There’s a lot of poverty. There’s a lot of change in governance. Opportunity abounds, only for the thick skinned and the speculator with good timing skills. Carter recommends Sri Lanka local currency bonds. The 10 year yields 11%. Five year debt pays around 9%. And get this, the Sri Lanka rupee has actually gained a little over half a percent against the dollar where most emerging market currencies have lost value.
“Sri Lanka is one of our biggest active positions. That and Uganda,” Carter says. Uganda doesn’t even register on the J.P. Morgan Emerging Markets Bond Index, that’s how off-radar it is. ”We have a whole basket of Uganda bonds on out to 8 years, which yields around 13%. The currency has been slowly strengthening against the dollar and we think the bond prices are undervalued,” he says.
The Uganda shilling is down 1.9% against the dollar this year.
In Moçambique, the Portuguese speaking Carter likes the so-called ”Tuna Bonds”. That’s debt owed by Ematum to finance its tuna fishing fleet. The $850 million offering was run by Russian bank VTB Capital and Credit Suisse last November and pays a yield of 8% currently.
“I like Ematum because the government has said that it will backstop the debt in the case Ematum couldn’t pay for the bond,” Carter says. If they ever needed to pay that bond, it would eat up nearly half of Moçambique’s cash reserves.
There are countries worth staying away from. Uganda is not one of them.
“I see no value in Mexico,” Carter says. “We can say a lot of good things about Mexico, but we’re not excited about it. Argentina we avoid altogether,” he says about Latin America’s third most populous country. “We’ve sworn them off years ago,” he concludes.
Whatever you do, don’t buy anything in these countries.
Source: Forbes Business
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