Adding Alpha Via Emerging Markets
July 28, 2003 — Global fixed-income mutual funds have been the belle of the ball for the past three years — and one of the most attractive offerings in this long-overlooked sector has been the $567.2-million Oppenheimer International Bond Fund (OIBAX). For the three-years ended June 30, this portfolio gained 12.46%, on average, making it the fifth best global bond fund for that period. For the five-year period, the fund gained 9.13%, the third-best results for a foreign bond fund.
Ruggero de Rossi, who took over management of the fund in March 2000, invests in bonds issued by more than 60 foreign governments of developed and emerging markets. “We look for value by using our in-house team of nine analysts to rigorously evaluate such parameters as a country’s interest rate environment, the strength of the local currency and the health of sovereign credit,” he said. “Based on our research, we derive a credit score for each country from which we determine the probability of default. To minimize volatility we like to have our investments in a broad number of countries.”
As of June 30, the fund had 32.1% of its assets invested in Western Europe, 25.0% in Latin America, 16.9% in Eastern Europe and Russia, 9.7% in Asia (excluding Japan), 6.8% in Japan, and 5.8% in U.S./Canada.
Also, as of June 30, the fund boasted an average credit quality of A-, an average duration of 3.3 years and an average maturity of 5.2 years.
As a value investor, De Rossi searches for underpriced markets with great upside potential, and currency fluctuations play a large role in his research. For example, De Rossi believes the euro may have “run its course” after a two-year rise against the U.S. dollar — consequently, he has recently scaled back his exposure to euro zone countries and added to his positions in Asia and Latin America. “We have been riding the wave of the euro all year, and recently we trimmed our exposure in Western Europe,” he said. “As long as the American economy remains sluggish, Europe will clearly not drive the world’s growth engine. Alternatively, we are seeing some growth in Asia, especially China, despite the SARS scare.”
De Rossi is maintaining a somewhat cautious stance on European debt markets. “Unlike the U.S., growth remains sluggish and therefore interest rates are likely to remain low for longer,” he noted. “Nevertheless, consumer prices remain high because of a drought-related supply shock and structural labor market constraints. Hence, European debt is unlikely to exhibit strong returns in local currency.”
Among other major developed markets, De Rossi is adding to his Japanese exposure — “Japan is a macro call,” he said. “The Nikkei has enjoyed a big rebound, the banking system there is improving and reforming, and more capital is moving to Japan from Europe and the U.S. Inflation is close to 0%, the savings rate is also coming down, which might mean that Japanese consumer spending is rising. Moreover, the Bank of Japan’s quarterly Tankan survey of corporate sentiment showed an unexpected surge.”
For the 12-month period ended June 30, the fund soared 21.52%, buoyed by the strong rise of the euro against the U.S. dollar [which plunged to a record low against the euro in May] and powerful returns from virtually all emerging markets. De Rossi attributes the fund’s recent outperformance primarily to his willingness to invest in the much-maligned emerging markets, particularly such oil-producing, developing nations as Mexico, Ecuador, Russia and Brazil, where bond markets have surged.
In fact, the top country in the fund is emerging markets giant Brazil, which represented 10.4% of assets as of June 30. De Rossi is particularly bullish on Brazil, where the popular new President Lula has promised pension and social security reform and the government appears committed to restructuring its massive debt. “Lula has encountered some resistance to his programs, but he has convinced foreign investors that Brazil is on the road to long-term recovery,” De Rossi noted. “Brazil’s currency, the real, is strengthening, interest rates are falling, and the spread over Treasuries continues to decline.”
All told, De Rossi has about 35% of the fund’s assets in emerging markets debt. “Our exposure to the emerging markets is a function of how much value we find there,” he said. “Right before the outbreak of the Iraq war in March, our allocation to emerging markets was as low as 15%. However, just after the September 11 attacks, it grew as high as 50% — during times of political crises, emerging market debt prices sink, thus providing us with great value and opportunity. In fact, in the aftermath of September 11, the spread among emerging markets debt was as high as 930 basis points in the aggregate; now they are at about 420, less than half.”
Moreover, for those who are concerned about the volatility of emerging markets, De Rossi counters that these economies “have matured since emerging markets across the globe collapsed in 1997 and 1998. If such crises were to arise again, they will likely be isolated in specific countries instead of spilling over into other emerging economies. In fact, I would point out that in recent years, emerging markets have exhibited lower volatility rates than the developed markets.”
De Rossi pointed out that emerging market debt has also benefited as certain countries like Mexico and Poland have had their debt upgraded to investment grade. In addition, “the quality of analysis of emerging market debt has improved and the IMF has required dramatically better economic data from the countries it lends money to.”
Emerging markets have performed so well, in fact, that the value-oriented De Rossi has had to scale back there — particularly in Russia, where the debt has been priced as if it were investment grade.
To illustrate his adherence to diversification and value investing, De Rossi cites the Philippines, hardly a nation popular with investors. “The Philippines has evolved from a period of extreme fiscal and debt deterioration to stabilization,” he said. “Moreover, their currency is still undervalued in real terms. Philippine securities offer good value and potential for upside.”
De Rossi does not think an anticipated recovery in the U.S. economy will hurt his fund’s performance. “The current account deficit in the U.S. remains so large that the U.S. dollar will likely be under pressure for the next few years as investors seek out higher-yielding currencies,” he said. “Even if stocks continue to perform well, investors will probably not pour money back into equity markets, having endured a three-year bear market for stocks. Hopefully, investors have learned to maintain a core allocation of fixed income securities, especially foreign bonds, which have proven to be a good diversification tool, have provided stable returns, and served as an excellent safe haven from equities.”