Dec. 15, 2004 — After a powerful rise in 2003, emerging market bonds continued to deliver strong returns this year, supported by continued cash flow into the sector, moderate global interest rates, and a maturation of the asset class as more ‘emerging’ countries enjoy sovereign debt upgrades, including Turkey, Brazil and Russia.
Kristin Ceva and Brian Matthews, co-managers of the $29.9-million Payden Emerging Markets Bond Fund (PYEMX), have steered this portfolio to a 11.7% gain for the 12-month period ended November 30, nearly matching the 12.0% return for its benchmark, the EMBI Global Diversified Index. For the three-year period, the fund climbed 13.2% annualized, underperforming the benchmark, which gained 15.2%. The fund has low volatility relative to its peers, as well as lower portfolio turnover, making it a more conservative offering.
“Performance in 2003 was largely driven by high returns from bonds issued by the credit-distressed, CCC-rated countries, and by historic cash inflows into the asset class as a whole,” Ceva said. “In 2004, we have continued to see spreads tightening, though not as dramatically as in the prior year. Also, 2004 witnessed more volatility, including a sell-off in May prompted by concerns about rising interest rates in the U.S. However, once we realized that the Federal Reserve would boost rates at a modest pace, emerging markets bonds rebounded nicely.”
Ceva’s fund emphasizes high-quality bonds [the fund's average credit quality is BB] issued by countries with improving macroeconomic fundamentals, and reasonable political stability. As a result, she tends to avoid unstable, credit-distressed nations, which have outperformed higher-quality debt issuers in recent years.
The fund, which is up about 9.1% year-to-date through November, has not only benefited from continued strong performance in emerging giants Brazil (up 11%) and Russia (up 9.5%); but also from moving into some new territories: Turkey, investment-grade South Africa, and two B-rated Latin economies, Uruguay (up 29.5%), and Venezuela (up 21%).
Ceva attempts to keep a healthy geographic diversification. The portfolio is invested across 14 countries. As of Sept. 30, 2004, it had 55.5% of its assets invested in Latin America, 33.5% in Eastern Europe, and 8% in Asia. The allocations in Latin America and Eastern Europe represented significant overweights relative to the benchmark. Ceva has reduced her exposure to Asia, now an underweight position, citing a lack of investment opportunities as spreads there have tightened.
The fund remains dominated by three major countries: Brazil, Russia and Mexico, which together account for 52% of assets, versus 30.7% for the benchmark. “The Russian markets struggled a bit due to the turmoil surrounding bankrupt oil giant Yukos, but that was offset by the country’s sovereign debt receiving a series of upgrades,” Ceva said. “Soon, Russian debt will have investment-grade status from all the rating agencies. This will open up new opportunities for higher-grade investors to put more money there. The country’s economic fundamentals are pretty strong, with a healthy debt-to-GDPratio. Russia does, however, present some long-term concerns, namely the slow progress of structural reforms by President Vladimir Putin.”
Ceva also continues to be bullish on Brazil. “The story here is strong, broad-based growth, both in the consumer-driven domestic economy and in the export sector,” she noted. “President Luiz Inacio Lula da Silva has done a good job politically in maintaining fiscal discipline. Brazil holds value as long as we see upgrade momentum. Standard & Poor’s recently upgraded Brazil’s debt to BB from single-B”
Although Ceva principally invests in U.S. dollar-denominated bonds, she has recently purchased some debt traded in local currencies, notably in Turkey and Colombia, as external debt spreads have narrowed too much, making them attractive. “Turkey boasts some improving fundamentals, they’ve done a good job in maintaining fiscal surplus, and they’ve begun serious negotiations to join the European Union (E.U.),” she notes. “Turkey is a long-term E.U. convergence play.”
The fund currently has about 91% of its assets in dollar-denominated bonds, with the reminder in local currencies. While Ceva expects to move into more local currencies, she does not expect that allocation to ever exceed 20%.
Another concern is the Fed’s commitment to raising interest rates, normally a dampening factor on emerging markets bonds. However, Ceva is not overly worried. She says emerging market countries are much better positioned to withstand higher interest rates than they were in 1994, the last time the Fed aggressively tightened. “These markets now have much better fundamentals, including stronger current accounts and attractive debt-to-GDP ratios,” she adds.
Ceva sees continued upside for emerging market bonds and is “quite positive” on the sector, even though her fund has posted positive returns for five straight years. One reason is because price increases in emerging market bonds have been underpinned by continued improvements in credit quality. “This represents a significant structural change, pushing emerging markets bonds into a transitional stage,” she said. Greater investment in the sector from pension funds, and overall attractive spreads with low interest rates, also contribute to her positive outlook on the sector.
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