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.