Flocking to Emerging Market Funds

<a href=www.novinite.com>The Bulgarian News.com For the record: 16 June 2003, Monday. Yahoo News

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 relative 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 having taken in $534.9 million in all of calendar year 2002. [By comparison, the sector suffered an outflow of $553.1 million the prior calendar year.] But in spite of the renewed investor interest, emerging-market bond funds remain overlooked and small -- the entire category comprises only about $5.475 billion in assets.

Still, if the funds continue to perform anything like Kristin Ceva's $95.3 million Payden Emerging Markets Bond Fund, they may pop up on more investors' radar screens. Ceva, who has managed the fund since its inception in December, 1998, emphasizes regional diversification in her portfolio and typically stays away from distressed-credit countries. For the three-year period ended Apr. 30, the fund gained 13.4% [on an annualized basis], vs. an 8.8% rise by the average global bond fund.

And while the fund's performance has outstripped that of its peers, its expenses haven't. Though the fund's annual expense ratio was increased from 0.80% to 0.90%, it remains below the peer group's average of 1.38%. Palash Ghosh of S&P's Fund Advisor recently spoke with Ceva about the fund's strategy. Edited excerpts from their conversation follow:

Q: What has driven this recent inflow of new cash into emerging-market bonds? A: At both the retail and institutional levels, investors are reducing their equity holdings and increasing their exposure to fixed-income securities. Moreover, with this low interest rate environment, high-yield bonds and emerging-market debt instruments have become more attractive. As the equity markets in the developed countries remain quite volatile, an increasing number of investors are uncomfortable with stocks and seeking safe havens.

Q: What kind of bonds do you look for? A: We invest in both sovereign and corporate bonds of emerging-market countries that are exhibiting improving macroeconomic and political trends. We like to emphasize geographic diversification across Latin America, Eastern Europe, and Asia.

Q: What are some of the fund's other significant data? A: Its average duration is about 6.2 years, and the average maturity is 13 years. However, we can invest without regard to duration or maturity. Q: What about credit quality? A: The fund's average credit quality is BB+. One cannot think of emerging-markets debt as being below-investment-grade anymore. That's a thing of the past. A number of emerging-market nations [including Malaysia, Mexico, South Korea, Chile, South Africa, and Poland] have had their sovereign debt upgraded in recent years to investment-grade status. For example, Mexico, which is the largest country [by allocation] in virtually all emerging-market bond indices, 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 the Ivory Coast.

Q: What are the fund's top country allocations? A: As of Mar. 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.

Q: What is the fund's sector breakdown? A: As of Mar. 31: corporate was 10%, and 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.

Q: What benchmark do you use? A: 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 65% of the index].

Our portfolio is closer in structure to the JP Morgan EMBI Global Diversified Index, which reflects our focus on regional diversification. As of Apr. 30, this index had 46.5% allocated in Latin America [including 12.3% in Mexico and 9.2% in Brazil], 23.4% in Europe, and 20.4% in Asia. Q: How have you performed against that index? A: Year-to-date through Apr. 30, the fund has gained 9.9% [gross of fees] while the index rose 10.3%. In calendar 2002, the fund jumped 10.6% [gross of fees], while the index went up 13.7%.

For the three years ended Apr. 30, the fund gained 14.3% [on an annualized basis, gross of fees], while the index rose 14.5%.

Q: Why have you been underperforming that index recently? A: Primarily because certain defaulted or CCC-rated countries like Argentina and Ecuador have delivered significant outperformance -- and we're not focused on such markets. In fact, Ecuador's debt markets have rocketed 54.69% this year, while Argentina gained 23.72%. Our focus on higher credit quality precludes investing in such risky countries.

Q: What's the premise for investing in Russia, which is currently your largest allocation? A: From a macroeconomic perspective, if you're a bond investor, you're 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, it has 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, it offers political stability, pretty good economic growth [partially supported by high oil prices], and progress on structural and economic reforms. We're comfortable with the overall economic and political fundamentals in Russia.

However, on a microeconomic level, there are some concerns about corporate governance. Russia has represented an overweight position in the fund as long as I have worked on it. The country has been the top-performing emerging market over that period.

Q: What about Mexico? A: We continue to have a favorable view of Mexico's debt markets -- it's considered a "safe haven" in Latin America. Because Mexico appears in the Lehman Aggregate Index, it attracts many "crossover" high investment-grade investors. As such, Mexico has a very broad base of investors.

Q: There appears to be some optimism about Brazil's economy now after years of turmoil. A: 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, tax, and pension. He's saying all the right things, but we are awaiting implementation of his stated programs.

Brazilian politics are extremely fractious. Some members of Lula's own party who oppose his reforms.

Q: 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 the Central Bank has intervened to stabilize the currency and is seeking to resolve the country's defaulted debt? A: Argentina is certainly on our radar screen, but they still have to go through a lot of restructuring 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.

Q: What other emerging markets are you strictly avoiding now? A: 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 received from the IMF and the U.S. will run out.

Q: In Europe you have positions in Romania and Bulgaria but not in the more prominent countries like Poland, Hungary, or the Czech Republic, which are joining the European Union. A: 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 the Czech Republic are extremely tight -- we just don't see much value nor upside in these countries.

Q: Which emerging markets have you been moving out of recently, and where have you been adding? A: In the fourth quarter of 2002, we began shifting out of Eastern Europe [as they had enjoyed a nice run-up], and we moved into Latin America, particularly Colombia, Peru, and Brazil, where security prices had gotten quite cheap.

Q: Isn't Colombia a high-risk area politically? A: 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 guerrilla presence. Moreover, Colombia is the third-largest recipient of aid from the U.S., so they have a lot of financial help.