From the August 2005 issue of Investment Advisor • Subscribe!

Discovering Emerging Yield

Mike Conelius of T. Rowe Price is sitting pretty with a conservative approach to emerging-market bonds

When you think of emerging markets, a conservative approach may sound like a paradox, but it's one way to describe the $347 million T. Rowe Price Emerging Markets Bond Fund (PREMX) and its manager, Mike Conelius. Of course, conservative within the realm of emerging markets bonds is not the same as conservative within developed markets, but then the yields aren't either. "In a way emerging debt is a bit of a hybrid between high-yield bonds--junk bonds--and the traditional government bond market," says Conelius. His focus on finding value and yield has earned this no-load fund four stars from Standard & Poor's, with four-star style rankings for one- and three-years; and three stars for five- and 10-years. Morningstar gives the fund three stars across the board.

According to S&P, the fund had a one-year return of 25.83% versus 19.67% for the Lehman Brothers Emerging Markets Index, and an annualized five-year total return of 14.98% versus 12.44% for its peers.

You recently added some new members to your team. How many do you have on the team now? It's a total of four people in the emerging markets area; two analysts--one covers Eastern Europe and one does a mix of Latin America and higher yielding Asian countries; a dedicated trader, and myself.

The analysts are Michael Oh and Julie Salsbery? Exactly, and Bridget Ebner is the trader. We also have folks in London that do developed countries and emerging or peripheral countries, and someone who looks at high-grade Europe also looks at Central Europe, Poland, Czech Republic, and Hungary, which are higher quality countries that we tend not to own in the dedicated portfolio but we could look at as alternatives. There are lots of eyes looking at emerging markets these days.

But they're not part of the dedicated team? No, they are part of the developed market team.

You have about $350 million in the Emerging Markets Fund now? In the U.S. fund, yes. We have a Japanese mutual fund that has about $300 million in it and we recently started a SICAV, which is a Luxembourg fund that has $3 million in seed capital.

Can you tell me about your investment process for the fund? We take a typical T. Rowe Price approach, which is very credit-oriented or research-oriented, and we do our own due diligence and own credit ratings for the countries that we follow. We look at what the rating agencies do, but they tend to be a lagging indicator as opposed to a leading indicator so we have to do our own credit work. Based on that fundamental approach, our style is longer-term in orientation, so we tend to have a position--whether it's a big overweight or a big underweight--for several years, as opposed to a more trading-oriented style. You can make money both ways; we favor a more fundamentally based approach. That leaves us with a relatively low turnover, about 60%-70%, which is very low compared to our peers. If we do have a high conviction in a country as either an underweight or overweight we tend to take a significant position. Back when we were negative on Argentina, we were almost completely out of the country even though it was 20% of the index. In Bulgaria, when we liked it several years ago, we had about a 10% allocation to the country, even though it was 2% of the index, so we will express a high conviction if we have it and we'll let that run.

What would cause you to sell a bond? It would really go back to what the fundamentals were doing and frankly the fundamentals [usually do not] change so dramatically that it would cause us to go from a 5% allocation to nothing. It is more evolutionary and since we are taking a credit view or fundamental view you wouldn't see that type of allocation change. Our positions are largely [based] on themes. A theme that requires a longer-term orientation, and has been very profitable for us, is restructurings. I've done this for about 20 years and have done most of the restructurings that we've seen in the asset class; I have an internal bias [toward] doing the legwork, the research, for a country like Argentina or Serbia that's going to go through a restructuring that may be time-consuming but ultimately will be rewarding. We build those positions over time, so it's evolutionary on the upside. As a view comes to fruition we trim the positions over time. [With] Bulgaria, one of the common themes that we've had in the portfolios for years was the convergence process. For fundamental and evaluation reasons we like the convergence process of East European countries moving toward the European Union (E.U.). We had a very large position in Bulgaria, and as it was upgraded by the market or by the rating agencies and spreads continued to tighten, we slowly trimmed that position as value became less attractive or maybe we found value elsewhere, so today we own no Bulgaria. It's much more of an evolutionary process.

When you talk about restructurings vis-?-vis South America do you mean after default? Yes, countries that are in default, either a recent default like Argentina had, or Serbia, which had been in default for a decade; doing the analysis and coming up with a reasonable valuation of what a restructuring would look like, including the timeframe. Sometimes the most difficult thing is building the position, finding the bonds, finding the loans. Because that is so time-consuming we have to take a longer-term orientation. They can be less liquid as well, and you have to take that into account.

When you decide on a country that you want to get into, is it then a value perspective? Exactly--especially down at the security-selection level--because there's no shortage of bonds to choose from. In Argentina, there were over 150 bonds that they defaulted on. Our analysis was not only--hey--Argentina is going to do a deal and the backdrop will be pretty favorable for the overall exit yield when Argentina is done defaulting and concludes restructuring; the fact that most people were underweight Argentina, again a positive for the country at the conclusion of the restructuring; but also a lot of analysis in picking which bond was the most attractive. In our analysis there were several local bonds, also in default, that we took advantage of, and some of the higher-coupon, non-dollar bonds. Most of our holdings were non-U.S. dollar bonds in Argentina; at the security-selection level that is another way of extracting value.

In the portfolio most of the bonds were governments as opposed to corporates. In the future would you choose more corporates--is it an opportunity issue? Historically, corporates have not been a great place to invest in emerging markets. If you think about it, most of the risk, most of the spread is at the macro level, the country level. Typically we're not paid much of an increment over the sovereign to take on corporate credit risk.

So it's more conservative to stay with government risk? Right. You can make money investing in corporates. I think you need to recognize that it's very dangerous to do proxies [such as] --we like Mexico--let's buy one of the Mexican telephone companies or a cellular company as proxy. I think that's dangerous because there's a lot of idiosyncratic risk at the corporate level that we choose not to [take]. We don't have the resources to do it in place, and I'd rather set that aside as opposed to just winging it. We focus our analysis on country level. To answer your question: down the road it may be an opportunity. We do have a very good high-yield group, corporate credit group here, some of the companies are already world-class companies so they own them because they're the local steel company, not necessarily because it's a Brazilian steel company. Right now I think our best opportunity in the local markets is at the sovereign level. Down the road, maybe corporates would feature, but we would really second that research effort to one of our credit analysts--the team that's in place already.

How do you measure political risk in the governments you invest in? It's a mosaic approach--there's no formula. Experience comes to the table. Over time, meeting with government officials, and more importantly watching their implementation, that's the main thing; having an ongoing dialogue with the countries including our due diligence trips, and watching their execution. There is no hard and fast rule. The bottom line is looking at the fundamentals of the country and its economic and social vulnerabilities. The main vulnerability most of these countries have is a high degree of debt, to a greater or lesser extent. If there is a country that has that type of vulnerability then you really need to be careful of their execution, their ability to come through with reforms. That's why the convergence process has historically been very important because that would tend to limit the policy mistakes that a country would make, because they had this overall goal that the citizenry accepted. With the Bulgarians--some of the politicians wanted to get into the E.U. so they would take some tough reforms because the result was going to be so positive. You don't have that degree of policy support in most of the Latin American countries, so their political risk tends to be a little higher. Mexico has it to a degree with the linkages with the U.S. It is something that we assess on an ongoing basis.

When you talk about the convergence process--with Bulgaria coming to the E.U., is coming to the E.U the principal issue or is there more to it than that? Well, the journey is where we make all our money, and as I said, we don't own any Bulgaria now and they're not in the E.U. yet. It's really a process of them establishing the right policy framework and the market recognizing that through a lower discount rate or a lower risk premium.

Can you talk about the non-correlative aspects of emerging markets and bonds relative to a U.S. investor's portfolio? The first caveat is, in a very low interest rate environment--which we've been in--correlations are all going up. The long-term correlation data is very compelling, mostly because we've had occasional crises in emerging markets and then very, very strong rebounds. We've had events that hit emerging markets including the Mexico, Russia, or Brazil crises, that tested the markets. The markets survived either through better reforms or IMF bailouts or both, and we had very strong recoveries. That makes the long-term correlation numbers versus U.S. Treasuries pretty compelling, but in the short run because interest rates are so low that tends to be a common denominator across all risk assets. The value of your mortgage, my bonds, a lot of equities, and commodity prices--the correlations are actually moving higher because of that common underpinning of very low interest rates. That's one cautionary point. The second is, and I tend to be pretty conservative, we've had all of these problems in many important countries--and they have resulted in strong reforms and strong credit improvements at the fundamental level, so the next 10 years should (touch wood), mean less volatility, but also lower returns. We should look more bond-like and less equity-like as we go forward.

Where would this find fit in a typical U.S. investor's portfolio? The main nuance is that most emerging debt is in hard currency, whereas [when] my colleagues in London are buying German bonds, they're buying in Euros or Japanese bonds in Yen. Most of what we buy is still dollar-denominated, although that is changing. If you think back 20 years, places like Italy and Portugal, and farther back, even Japan and Australia were the newcomers in the market, and they tend to be high-yielding securities. Over time they went through their own reform process moving away from [their old] socialist policies and moving toward new socialist policies with the E.U. Their credit quality improved to where the risk premium that the market demanded slowly evaporated--and most of that risk premium was because of their currency risks, not much because of fiscal risk. You are sort of seeing the same migration in our market. Now, about half of our countries are investment grade. That's why I say that they're a bit of a hybrid between high-yield and higher-quality government bonds. Where it would fit: first have a fixed income allocation; lots of people are under-invested in fixed income. Then it should be a small part, maybe 5% of a well-diversified portfolio, if you're willing to take some volatility. A lot of our countries benefit from higher commodities prices; I wouldn't want to go so far as to say it's inflation protection, but to some degree, it is--these are commodity producers. [Investors need to recognize] that past gains are really not sustainable because those were the by-products of one-off events.

You don't think that there will always be other events? These are emerging markets, and they've been emerging for hundreds of years; Brazil is the country of the future, and always will be. I think there will be future events. I'm somewhat heartened that at this point in the cycle we would have seen much more significant borrowing, and much more complacency at a policy level, and we're not seeing that, at least, not seeing that broadly. Countries are using this opportunity to reduce debt, to build hard-currency reserves, to deepen their own domestic bond market, so if anything, maybe some of the risks are that investors--not so much the countries, investors--are longer-duration because a lot of countries have taken the opportunity to lock in long-term, fixed-rate debt, so the duration of the asset class has gotten pretty long. More investors are investing in the local markets so they're taking on more currency exposure. The bottom line is that the countries are still inherently vulnerable to the extent they have to rely on foreign savings, because although a lot of them are running account surpluses now, they still have a large stock of debt with foreigners--that's a vulnerability.

You had more to say about dollar-denominated bonds? The one trend in our portfolio and in the market in general is, as the countries mature and spreads compress, people are looking for value in other areas. In Mexico, for example, we tend to be underweight in hard-currency debt; it trades around 150 basis points over treasuries. Pemex, their state-owned oil company trades a bit cheaper than that, but it's still pretty fully valued. Their local bond market, the Mexican Peso bond market, is attractive. They've been very aggressive in raising rates to dampen inflation expectations and now they've stopped raising rates. Local markets like Mexico are more attractive. Over time the risk characteristics of our funds or the asset class may shift to be a little bit more exposure to local currencies and a little less to U.S. interest rates. We're about 6% in local currency now so it's not the dominant feature of the fund but it's a nuance people should be aware of.

What effect do the Federal Reserve's rate hikes have on the portfolio? Emerging markets have been the tail of the dog--they are the residual asset class. They tend to be significantly affected--any speculative investment tends to be affected by cost-of-money and the Fed Funds rate tends to be the lowest cost-of-money, so if that was going up then, in theory, everyone else's cost-of-money should go up along with it. So far, the Fed's hikes have not had much of an effect on the overall yield curve, and have not had much of an effect on risk appetite--possibly to Greenspan's chagrin. If the Fed was going to be on a relentless, aggressive [program] of rate hikes we would have an event--we would have probably a hedge fund getting caught on the wrong side or some of the speculative money that has gone into commodity trades or the so-called "carry trades" either in emerging currencies or even developed market currencies--some of that would have to be unwound and that would have a negative effect on all risk assets including emerging. The fundamentals are in good enough shape that we can withstand higher rates, but what that means is that there would not be a credit event in emerging, but we would sell off if the Fed were going to be that aggressive. I think that is a chance that the Fed is closer to being done than not.

What effect do higher oil prices have on the portfolio? Does that impact two ways--one with the commodity [export] and the other with the cost [of import]? There are definitely winners and losers. On balance, emerging countries are exporters of oil. It certainly hurts some of the Asian countries that don't have oil--they tend to be some of the higher-quality countries. Likewise in Central Europe although Turkey is an importer of oil so that's a cost for them. Some Caribbean countries are heavily affected by higher oil prices. The last time we had a surge in oil prices people considered it a tax on growth--it was doing some of the work for the Fed, cooling demand. Now that doesn't seem to have the same credence; people are looking at it as cost pressure. It's clearly been a drag on European growth and possibly would be a drag on Japanese growth. I would say overall it's a mild positive for emerging countries. It's a tax on growth and it's also positive to their trade accounts.

Is there anything else our advisors should be aware of regarding the fund? There's an early redemption fee for short-term trading. I would be mindful that the returns we've seen to date are a bit outsized. We've done particularly well; we're at the top of the pack year-to-date [up 8.59% as of July 1, according to Lipper]. The leading contributor for that performance was Serbia; we had a substantial positioning in Serbia, about 6% of the fund, [even though] it was not in the benchmark. It is now but hadn't been the whole time. Most of our peers don't own it so that was an example of our moving beyond the mainstream, beyond the index, looking for value. Argentina is also a significant position for us. We have been overweight both performing and defaulted debt for some time. We chose to participate in the restructuring (some investors were holdouts), so now all our bonds are performing (no longer in default). That decision is paying off nicely as investors slowly warm up to Argentina again.

What are your largest holdings? Largest overweight [holdings] would be Argentina, Serbia, Jamaica, Viet Nam, and Turkey. We own no generically high-quality Asia including Malaysia, China, and Korea; and have no exposure to Ecuador, or Dominican Republic.

Would you talk about your winners and losers? Argentina and Serbia have been pretty positive. Dominican Republic has been a negative; both Dominican Republic and Ecuador are too-high-beta countries that, in our eyes, have really not done anything in terms of fundamentals and reforms. If anything, Ecuador has deteriorated but it still has a very high yield. We left money on the table by not owning Dominican Republic, and Ecuador would have done well because of the high running yield. Ecuador would have been nice to own but I just couldn't stomach it.

Why did your winners perform so well? It was mostly the long-term value of the restructurings. Argentina was a pariah in everyone's eyes, and I tend to be a contrarian, so I like it when most people don't like it because there's no one left to sell. When the sentiment got more positive on Argentina we benefited from that collapse in discount rates. In Serbia going into '02, it was a combination of a move away from Latin America--I liked having something non-correlated to Latin America--and it was one of those few restructurings that immediately moved into a convergence trade. [Serbia] was a restructuring story that had a lot of value to extract out of the deal itself and we saw that late last year and early this year. Now it's a convergence trade so more people will be looking at it as a long-term story moving closer to the E.U. It went from one theme to the other--from restructuring to convergence.

Which index do you compare yourself to? The J.P. Morgan M.V. Global.

Do you own this fund yourself? Yes.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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