From the August 2011 issue of Investment Advisor • Subscribe!

Uncommon Bonds

An evolving bond market has opened new opportunities for investors who want international exposure without sacrificing stability

It's only natural, says Scott Colyer, CEO and CIO of Advisors Asset Management, that U.S. investors have focused their international investing horizons on equities, since equities have dominated the investment universe and continue to hog the lion's share of domestic investment portfolios.

Internationally, too, people have had a greater affinity for equity markets because they are more homogeneous, more developed and easier to understand and navigate than their bond counterparts.

Even today, Colyer says, most investors believe that they need look no further than equities to get the best out of their international exposure. But people who want to generate income, and who know that the best investment opportunities today are found overseas, are doing themselves a great disservice if they're not investing in international fixed income as well. As much as foreign equity markets offer great potential for reward, so too, says Colyer, do overseas bond markets.

"The bond markets have been changing considerably over the past decade, and not only has international product become more prevalent, the ways in which one can trade it have always improved and many of the risks that used to exist have been mitigated," he says. "Today, many U.S. investors have a genuine need and desire to diversify away from the U.S. dollar. Foreign bonds allow us to do just that."

Whether it is in the form of emerging or developed market debt; sovereign or quasi-sovereign bonds; or straight corporate or structured products, the international fixed income markets today are a real treasure trove of opportunities that span the length and breadth of the globe.

"The market is so much bigger than it was 10 years ago, when it was mostly government bonds that were available," says Mark Beischel, co-manager of Ivy Investment Management's Ivy Global Bond Fund. "Not only do we now have so much more corporate issuance on a global basis, we've also seen so many changes in where the issuance is coming from."

The international fixed income market, Beischel says, has come a long way since the days when top brass, quasi-sovereign issuers like Mexico's state-owned oil company, Pemex, and Brazil's Petrobras, were among the few issuers borrowing funds. Those names are still very much present, but today, there's also a plethora of credit-worthy Latin American issuers with strong balance sheets from places like Colombia and Argentina. A couple of years ago, Ghana and Gabon—two African nations that many may not have expected to be able to issue debt internationally—successfully sold sovereign issues.

Today, the greatest amount of new corporate bond issuance is coming from the Asia-Pacific region, Beischel says, from places like Indonesia and Thailand, and new local currency corporate bond markets are also developing in unexpected places like China. As financial systems continue to modernize and strengthen, and as global corporate finance increasingly moves away from the traditional bank lending model, bond financing will become more and more popular, he says.

U.S. investors looking to get in on these new opportunities stand to gain immensely because they will be able to benefit from both the stability that is characteristic of bonds and the income stream that they provide.

"In the past 10 years, people's portfolios have been blown up twice by equities and once by the housing market, whereas in the past 13 or 14 years, bonds have actually done better than the S&P, and with less volatility," Beischel says. "Add that to the general aging of the U.S. population: People don't need volatility, they need stability in their portfolios."

While international bond funds have been in existence for years, the asset class is now attracting new participants who are finding different ways to play it. Advisors Asset Management has long been trading in and offering its clients individual international bonds, but the firm has only recently structured an investment product—a unit trust—dedicated to international bonds, which Colyer says was a runaway success.

"There is a huge amount of demand for these kinds of products as the interest in international fixed income grows," Colyer says.

The trust invests in the tried-and-tested international fixed income marketplace, in investment-grade names that have global business, that have issued debt denominated in hard currencies and are highly liquid and tradeable.

"But given the success of the product, we would look to do more, and the natural progression would be to explore in greater depth companies from emerging and frontier markets," Colyer says.

There are many different kinds of bond funds on the marketplace. Investment Advisor talked to a few managers with different approaches to getting the best out of the international bond asset class.

The Global Bond Fund—Part 1
On a recent roadshow, Michael Mata, portfolio manager of ING Investment Management's Global Bond Fund, heard investors raise repeated concerns about inflation and the correlated value of the U.S. dollar.

"This is why having a global fixed income allocation with just a little bit of U.S. in it makes sense, and gives an investor a great deal of flexibility," he says.

Being able to play against inflation and the falling value of the dollar is one of the greatest advantages of running a global fixed income fund. Mata and his team are able to go in and out of markets as they see fit. To do so, they score countries based on where respective governments are in their monetary policy cycles and the impact that that has upon individual company business cycles. Depending on their assessment, they will then invest in a range of bonds, including sovereign and corporate credit, and structured products such as commercial mortgage-backed securities (CMBS).

"A global, diversified fund is the best way to get the most out of international bonds," Mata says.

The flexibility of a global portfolio like the ING Global Fund at once protects against and capitalizes on global interest rate and currency trends, Mata says.

"The [United States] is not anywhere near the point where we'd start to see rates rising, but elsewhere in the world there are places like Australia and Brazil where they are closer to the end of the tightening cycle, where economies have done well and yields are high," he says. "It's only because we have a flexible fund that we can modify our portfolio to take advantage of where we are in the cycle."

The ING Global Bond Fund is currently invested mostly in investment-grade corporate credit with some CMBS holdings. On the sovereign side, Mata has taken on interest rate risk in places that are closer to the end of the tightening cycle, such as Brazil, Indonesia and South Africa, where the fund owns five- or 10-year bonds. It is also positive on some of the smaller developed markets, such as Norway and Sweden, which have robust economies and exposure to commodities.

The Dedicated Global Emerging Markets Fund
Through a dedicated fund, David Hinman, manager of the Forward EM Corporate Debt Fund, has chosen to zero in on the best opportunities in the $600 billion emerging market corporate bond market. His reason, though, is less because of the growth story that's tagged to the emerging markets and more because of the additional yield per unit of duration and yield per credit risk that these bonds offer.

"You get 100 to 200 basis points more yield for both duration and credit risk [in emerging markets corporate bonds] compared to U.S. bonds," Hinman says. "You can, for example, construct a double-B rated emerging market bond portfolio with a 7% yield."

Hinman is not spoiled for choice when it comes to finding investment opportunities: "Last year, there was $180 million in new emerging market issuance, and currently, there are about 1,000 different issues in the emerging market corporate space," he says.

The market, he says, continues to expand to include small-cap companies that need capital to expand, companies with strong balance sheets for which it makes more sense to issue debt than equity.

To find these opportunities, Hinman ascertains the strength of country fundamentals, then industry fundamentals and, finally, individual company prospects.

Currently, Eastern Europe offers the best opportunities, he says, and infrastructure bonds in Russia, Ukraine and Kazakhstan are particularly interesting. Hinman is also finding value in Nigeria and in Latin American agricultural bonds. But unlike the equity markets, where many still are focusing on Brazil, he believes better fixed income opportunities are to be had in the corporate sector of countries like Argentina, Mexico and Venezuela. In Asia, equity market darlings India and China aren't on his list either (India, in fact, makes up only 10% of the emerging markets corporate bond market), since he finds better opportunities elsewhere in that region.

"Investors still tend to think that owning emerging market debt means owning only the international debt of countries, but the corporate bond universe is really growing nicely, and people should get some exposure to it," Hinman says. "Unlike in equity, which is earnings and growth driven, corporate debt is about the security of the issue, the call-and-put dynamics, the amount of debt a company has maturing, and so on. The emerging part of the world offers many good opportunities and fairly good investor protection, and offers good diversification."

The Global Bond Fund—Part Two
Dan Vrabac and Mark Beischel, co-managers of the Ivy Investment Management's s Ivy Global Bond Fund, have allocated two-thirds of their portfolio to corporate bonds. This is different from other global funds, Vrabac says, which tend to have a concentration of government or agency bonds, and the rationale is that corporate bonds enhance yield and keep duration lower.

Although there are issuers from more than 20 different countries represented in the fund, the vast majority of those bonds are denominated in U.S. dollars at the current time, but Ivy, unlike other global bond funds, has the additional flexibility to move outside of U.S. dollar-based investments into foreign currency bonds if fundamental analysis dictates.

"Overall, we're trying to give people exposure to other markets," Vrabac says. "The U.S. bond market is less than half of the total bond market, so if you're in a global fund, you have the opportunity to go into different markets and take advantage of the tremendous amount of very solid corporates outside the [United States] that are issuing debt at higher rates compared to a comparable U.S. credit, and that offer greater yield for less risk."

Being able to invest globally also means being able to take advantage of different dynamics and trends across the world. Beischel cites the example of Arcos Dorados, a high-quality Argentine issuer of a 10-year bond that came last fall with a 7.5% coupon, but because of its country of domicile, received a low rating. Arcos Dorados (which is Spanish for Golden Arches) has about 1,500 franchises across Latin America; it is a very profitable and solid business, Beischel says, and one that the Ivy Global Fund, because of its flexible mandate, can take advantage of.

Flexibility affords diversification, which in turn produces income. Duration, though, is also an important parameter in managing the fund, particularly in today's low interest rate world, so the fund's target duration is instruments that mature between "2 and 2.5 years," Vrabac says.

The Local Currency Fund: China
The driving force behind Guinness Atkinson's newly launched local currency China corporate bond and currency fund is the appreciation of the Chinese renminbi vis-à-vis the U.S. dollar.

"The increasing pool of deposits in Hong Kong, a result of China allowing currency in international trade settlements, will only get larger because China wants to increase the internationalization of its currency," says Edmund Harriss, who manages the Guinness Atkinson Renminbi Yuan & Bond Fund.

Renminbi is the official name of the Chinese currency; yuan is the unit of currency.

"As China increasingly uses its currency as a tool for economic management, there will be a better allocation of capital and companies will find it more attractive to use the bond markets to raise funds," Harriss says.

Although most Chinese companies are still raising about 90% of their capital through bank lending, Harriss believes that China's continued engagement with the rest of the world will encourage more companies to use the bond markets, and this will result in more issuance of greater size and more rational pricing.

Thus far, the offshore renminbi market consists of renminbi held in Hong Kong, which (apart from Macao) has the only official clearing system for renminbi outside Mainland China. However, an agreement is expected soon that would permit renminbi clearing in Singapore, which would be the first outside China's sovereignty and would require more distant regulation and monitoring via the Monetary Authority of Singapore, thereby underscoring China's desire to extend the use of its currency outside its borders.

"[The renminbi currency and bond market] is a developing and maturing market, but what's surprising is the speed at which it's happening," Harriss says.

He gives the example of a bond issued by Beijing Enterprise Water, whose five-year maturity makes for the longest local currency tenor to date. A range of other Chinese companies are in the pipeline with similar issues, he says, and multinationals like Unilever are also in line to issue more debt with longer tenors.

Of course, investing in Chinese local currency instruments is still such a far-off prospect, it's only natural that people fear a market that is so remote, so young and fraught with risk. Liquidity is a huge concern, as is the ever-present threat—real or perceived—of China reversing its market-oriented course and heading back in the opposite direction.

But, says Harriss, "China's role in the global economy means its currency has to be freely usable."

Harriss is banking on his 18-year experience and expertise in the Chinese market: "I know my way around. I have a sense of what companies are good, what issues are priced keenly and where there is value to be had," he says. "As more issues come, we will see a greater understanding of the market, more ratings, greater governance and transparency."

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