Emerging market bonds have performed very well this year, buoyed by unprecedented cash inflows as increasing numbers of investors have found this high-yielding asset class a relatively safe haven from the volatile equity markets of the developed countries. Indeed, according to the Financial Research Corp., emerging market debt funds received $712.2-million in new money through the end of April, after taking in $534.9-million in all of 2002. By comparison, the sector suffered an outflow of $553.1-million in the prior calendar year.
Despite renewed investor interest, emerging market bond funds remain overlooked and small — the entire asset class comprises only about $5.5-billion in assets.
Kristen Ceva, portfolio manager of the $95.3-million Payden Emerging Markets Bond Fund/R (PYEMX), emphasizes regional diversification in her portfolio and typically stays away from distressed-credit countries. In fact, as many emerging markets have recently had their sovereign debt upgraded to investment grade, Ceva has an increasing number of relatively high-quality issues to choose from.
For the three-year period through April, the fund gained 13.4%, on an annualized basis, versus an 8.8% gain for the average global bond fund. The fund’s annual expense ratio was increased from 0.80% to 0.90%, but remains below the peer group’s average of 1.38%.
Ceva has managed the fund since inception in December 1998.
The Full Interview:
S&P: What has driven this recent inflow of new cash into emerging market bonds?
CEVA: At both the retail and institutional levels, investors are reducing their equity holdings and increasing their exposure to fixed-income securities. Moreover, with low interest rates, high-yield bonds and emerging market debt have become more attractive. As the equity markets in the developed countries remain quite volatile, an increasing number of investors are looking for safer havens than stocks.
S&P: What kind of bonds do you favor?
CEVA: We invest in both sovereign and corporate bonds of emerging market countries which are showing improving macroeconomic and political trends. We like to emphasize geographic diversification across Latin America, Eastern Europe and Asia.
S&P: What are some of the fund’s other significant data?
CEVA: The fund’s average duration is about 6.2 years. and the average maturity is 13 years. However, we can invest without regard to duration or maturity.
S&P: What about credit quality?
CEVA: The fund’s average credit quality is BB+. One cannot think of all emerging market debt as below investment grade anymore — that’s a thing of the past. A number of emerging markets, including Malaysia, Mexico, South Korea, Chile, South Africa and Poland, have had their sovereign debt upgraded in recent years to investment grade.
For example, Mexico, which is the largest country by allocation in virtually all emerging market bond indexes, has a relatively high rating of BBB. Our fund’s average credit quality is typically higher than that of most emerging market indexes because we seek to avoid distressed-credit or nonrated countries like Nigeria and Ivory Coast.
S&P: What are the fund’s top country allocations?
CEVA: As of March 31: Russia, 19%; Mexico, 17%; Malaysia, 8%; Peru, 7%; Brazil, 7%; Bulgaria, 6%; Colombia, 6%; Philippines, 5%; Panama, 5%; Romania, 5%; Ukraine, 4% and South Africa, 4%.
As a risk-control measure, we typically will not permit any one country to account for more than 20% of the fund’s assets.
S&P: What is the fund’s sector breakdown?
CEVA: As of March 31: corporate, 11%; sovereign, 87%. We limit our exposure to corporate debt in the emerging markets to about 15% because the corporates in these countries often lack liquidity.
We purchase corporate debt in countries where we have confidence in their sovereign risk. Our corporates tend to reside in upper-tier, well-managed companies like Televisa in Mexico.
S&P: What benchmark do you use?
CEVA: While most emerging market bond funds use the J.P. Morgan EMBI Plus Index, we feel that index is too heavily concentrated in just three countries: Mexico, Brazil and Russia, which together represent more than 65% of the index.
Our portfolio is closer in structure to the J.P. Morgan EMBI Global Diversified Index, which reflects our focus on regional diversification. As of April 30, this index had 46.5% in Latin America (including 12.3% in Mexico and 9.2% in Brazil), 23.4% in Europe and 20.4% in Asia.
S&P: How have you performed against that index?
CEVA: Year to date through April 30, the fund has gained 9.9% while the index rose 10.3%. In calendar 2002, the fund jumped 10.6%, while the index went up 13.7%.
For the three years ended April 30, the fund gained 13.4% on an annualized basis, while the index rose 14.5%.
S&P: Why have you underperformed that index recently?
CEVA: Primarily because certain defaulted or CCC-rated countries like Argentina and Ecuador have significantly outperformed — we are not focused on such markets. In fact, Ecuador’s debt markets have rocketed 54.7% this year, while Argentina gained 23.7%. Our focus on higher credit quality precludes investing in such risky countries.
S&P: What is the premise for investing in Russia, your largest allocation?
CEVA: From a macroeconomic perspective, if you’re a bond investor you are looking at a country’s ability to pay back its debt. Russia has done an excellent job in reducing its debt-to-GDP ratio to less than 40%. In fact, they have a better debt-to-GDP level than such European nations as Poland or Hungary.
There are no concerns about default risks for the foreseeable future, and Russia has current account and fiscal surpluses. Moreover, Russia offers political stability, pretty good economic growth (partially supported by high oil prices), and progress on structural and economic reforms. We are comfortable with the overall economic and political fundamentals in Russia. However, on a microeconomic level, there are some concerns about corporate governance. Russia has been an overweight position in the fund as long as I have worked on this fund — it has been the top-performing emerging market over that period.
S&P: What about Mexico?
CEVA: We continue to have a favorable view of Mexico’s debt markets — it is considered a safe haven in Latin America. Because Mexico appears in the Lehman Aggregate Index, it attracts many crossover investment-grade investors. As such, Mexico has a very broad base of investors.
S&P: There appears to be some optimism about Brazil’s economy now after years of turmoil.
CEVA: We currently have a neutral weighting in Brazil, reflecting our cautiously optimistic stance on the country. Brazil’s newly elected President, Luis Inacio Lula da Silva, apparently seems committed to reforms in social security, taxes and pensions. He is saying all the right things, but we are waiting for him to implement his programs. Brazilian politics are extremely fractious; there are members of Lula’s own party who oppose his reforms.
S&P: You mentioned you have no exposure in Argentina, but aren’t things improving there, given that the Argentine peso recently reached a 12-month high, and their central bank has intervened to stabilize the currency and is seeking to resolve the country’s defaulted debt.
CEVA: Argentina is certainly on our radar screen, but they still have to restructure a lot of their defaulted debt. We don’t have a good enough idea of how the new President-elect Nestor Kirchner will treat this process. There are simply too many variables and political risks in Argentina now.
S&P: What other emerging markets are you avoiding now?
CEVA: Turkey and Venezuela are very high-risk markets now. The situation in Venezuela could be particularly explosive, given the social tensions, high unemployment, oil strikes and turmoil surrounding President Hugo Chavez.
Turkey has very difficult debt dynamics — eventually the money they have received from the IMF and the US will run out.
S&P: In Europe you have positions in Romania and Bulgaria, but not in more prominent countries like Poland, Hungary or Czech Republic, which are joining the European Union.
CEVA: We see more value in the long-term convergence stories of Romania and Bulgaria — these nations are likely to join the EU by 2007. The spread valuations in Poland, Hungary and Czech Republic are extremely tight — we just don’t see much value or upside in these countries.
S&P: Which emerging markets have you been moving out of recently, and where have you been adding positions?
CEVA: In the fourth quarter of 2002, we began shifting out of Eastern Europe, which had a nice run-up, and we moved into Latin America, particularly Colombia, Peru and Brazil, where securities have gotten quite cheap.
S&P: Isn’t Colombia a high-risk area politically?
CEVA: President Alvaro Uribe of Colombia is vastly different from Chavez of Venezuela. Uribe’s government is highly respected and seems committed to enacting fiscal and structural reforms to improve the country’s debt-to-GDP ratio. They also seem genuinely committed to fighting the nation’s guerrillas. Moreover, Colombia is the third largest recipient of aid from the U.S., so they have a lot of financial help.