Emerging Markets Bonds: Key Themes for 2015
ERIC FINE: There are several key themes for the portfolio in 2015. Number one is Russia. We continue to want no exposure to Russia or the region. We see the geopolitical situation there as intractable, as well as subject to expansion and considerable headline risk. The bottom line for us regarding Russia is they have $100 billion of corporate debt coming due every year and their more than $400 billion in reserves is needed for too many things. It’s needed to service debt, defend the foreign exchange rate, recapitalize the banking system, and stimulate growth. We don't think the upside-downside makes sense in the bonds. That's number one and it’s an ongoing theme. We still have no Russia exposure and we’re trying to avoid the region.
Number two is we are continually concerned about local currency. The main reason is emerging markets growth continues to disappoint relative to U.S. growth. An additional reason is a great deal of money has gone into local-only and we think that the existence of local-only is going to be questioned by the market. It has generated higher volatility and lower returns than I think a lot of the deeper, committed investors were expecting. Therefore I wouldn't be surprised to see technical pressure or outflows from these funds. That's a second theme.
The third theme is again a no, i.e., something that doesn’t pass our process test: corporates. There are good corporates that are cheap. They are also illiquid. We see much more downside than upside in an adverse scenario. It has begun to happen in some sectors. Russian corporates were hit and then Brazilian corporates were hit. Then the Chinese property sector was hit and energy bonds were hit; this adds up and affects the expectations of other portfolio managers. Our concern is that at some point they're going to start worrying about the illiquidity of their whole portfolios. Those are the three "nos" essentially that are ongoing themes: the three things that our process tells us to avoid.
What do we like? About 65% of our portfolio is composed of long-dated, investment grade, dollar-denominated government bonds, i.e., sovereign bonds. Boring old things. Why do we like them? Our process tells us that credit curves are steep and we're supposed to like the long end of these bonds. Then the question is: what about duration? The Fed is going to hike. Aren't we supposed to hate duration? That seems to be what the newspaper says every day but we don't think so. I think the Fed may hike but it’s important to note that the Fed hiked 425 basis points in '04 and '06 and nothing happened to the ten-year. That is number one.
Number two is it's not just about Treasuries. It's about Treasuries minus JGBs and Treasuries minus Bunds. Those interest rates have been rising. What does that mean? It means a dollar rally. What happens 12 months after the dollar rallies? The U.S. economy normally turns down, which is why we're comfortable with duration. Why specifically these bonds? What else argues for them? What is it specifically about long-duration, high-rated, dollar-denominated bonds? They're almost all net creditors. They have more dollar reserves than dollar debt, with debt management offices so they can intervene in the market. That's pretty hard to argue with. Additionally, they're paying more in principal and interest than they're borrowing (about $15 billion more in principal and interest this year than what they're borrowing from the market). Therefore technicals are very good. Finally, we like that it happens to be an out-of-consensus view. According to the J.P. Morgan surveys, the market is underweight that sector. Now that's not a reason but it's nice when we end up there. This is one big part of our portfolio.
The more idiosyncratic or lower-rated exposures that we have are Vietnam and Argentina. They are old and, similar to much of what I have discussed, they don’t entail much that is new. They represent longer standing views. One word on both of them is: re-rating. Vietnam is a B on its way to BBB, in our opinion. Argentina is very solvent but not liquid and I use “liquid” to refer to the economy rather than the bond. The bonds are liquid but the economy doesn't have much liquidity. It does, however, have good solvency. This year there will be an election and we think any of the candidates will give Argentina access to the market. The liquidity answer will be provided. In fact, the political scandal is going to increase the chances that the current president is out, that the election is early, and that the most radical reformist candidate could be the next president, which was not a high-probability event before this political scandal.
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