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Debt investor scorecard: Beating the benchmark

May 1, 2013

Latin debt funds have had a solid run in recent years. But replicating record returns will prove ever more challenging

By Katie Llanos-Small

The aftermath of the global financial crisis has been unkind to some. But for the emerging markets, successive years of economic gloom in the developed world have proved anything but a drag.

Ultra-low interest rates in the West have given rise to a surge in capital flows to high-growth emerging regions. And investors betting on emerging market debt have had an impressive run: simply tracking the JPMorgan EMBI Global Index would have returned over 10% on an annualized basis over the three years to the end of March.

The top managers have done much better. The funds in LatinFinance's 2013 debt investor scorecard have all beaten that benchmark.

GMO's Emerging Country Debt Fund tops the ranking, with returns of close to 17% over the past three years. The $2.3 billion fund allocates close to 40% of its assets to Latin America.

When it comes to replicating such returns in the years ahead, top managers say local currency paper and corporate debt offer the best opportunities.

"The greatest value in the next 12 months will be combination of corporates and local currency bonds," says Blaise Antin, head of sovereign research at TCW.

The firm's $7.3 billion Emerging Markets Income Fund returned 14% last year, and 15% on average over the past five years.

"In local currency, we've been biased in favor of Mexico," he says. "The peso has been the best performing currency this year."

The local yield curve responded favorably to rate cut in March - the first such move since 2009 - and any further easing would likely contribute to a further rally in local bonds, Antin adds.

TCW is not alone in liking Mexican peso-denominated bonds. The currency has steadily strengthened since June 2012 when it traded at 14.31 to the dollar.

Enthusiasm about ambitious reforms being driven through by the new Enrique Peña Nieto-led administration pushed the currency up to 12.32 to the dollar in early April.

Sam Finkelstein, portfolio manager at Goldman Sachs Asset Management, also lists peso paper as a favorite.

"The potential is strong for FDI into oil and gas if the government is able to push through reform," he tells LatinFinance. "The story overall is a positive one."

Goldman's $2.9 billion Growth and Emerging Markets Debt Fund returned 12.6% in the year to the end of March, and has averaged returns of 11.8% over the past three years. Local currency allocations made up 4.5% of the portfolio in February, with three-quarters of that in sovereign paper.

Real expectations

Debt denominated in Brazilian reais also offers some value - particularly when held up against Brazilian in dollars, Finkelstein says.

"Generally I'd be critical of the level of investment, the role of government, and would like to see more reforms," he says.

"A lot of the positives, terms of trade and credit growth, are behind the country. The only investment we like is local bonds with the FX hedged." Brazil local bonds offer high nominal yields at roughly 9.5%, he notes.

Local currency bonds are not attractive everywhere, though. Colombia last year cut the tax on profits earned by foreign investors in the local market from 33% to 14%. While that may lure some more investors in, overall the market is not exciting international portfolio managers, says Antin.

The Colombian peso has dropped 3% year to date and there are concerns it could depreciate further. "With the central bank cutting rates and the government talking down the currency, it's hard to get bullish," he says.

The yields on offer on Colombian paper are unattractive for many international accounts.

"In local markets, we look for a combination of high carry and the prospect of currency appreciation. Appreciation isn't really something we're going to find in the Colombian peso over the next six to 12 months. As for carry in the local market, we currently see better opportunities among some Colombian corporates compared to government bonds."

Despite appreciation pressures, the Peruvian sol is also flagging this year, following intervention by policymakers. Mexican local currency bonds helped Aberdeen's Emerging Markets Bond Fund in January. But overall, portfolio manager Edwin Gutierrez says emerging market currencies have not performed as well as some expected this year.

"We came into this year thinking it would be a decent one for emerging markets currencies," he says.

"EM equity inflows are supportive, but strong EM currencies haven't materialized. There's a home bias, and buying of US assets has led to dollar strength versus euros, yen and emerging market currencies. It has been difficult for local currencies to rally with a strong bid for the dollar."

Beating inflation

Aggressive monetary expansion in developed markets has ramped up another long-lingering concern for debt portfolio managers in LatAm: inflation. But there are home-grown factors also at play.

At 0.9% in 2012, Brazilian growth is a concern for the entire region, says Antin. While government measures are expected to prompt a rebound - analysts at Itaú reckon the economy will expand 3% this year and 3.5% in 2014 - investors are also vigilant for signs of inflation.

Antin says the worry is that the central bank will "push the boundaries a little too far" and focus excessively on growth at the expense of price increases.

"If the policy mix results in rising inflation pressures - either in Brazil or other countries - inflation-linked bonds can provide an important safety valve for fixed income investors," he says.

The central bank may offer a couple of "symbolic" rate rises this year, says Gutierrez, but this is unlikely to counterbalance inflation expectations. Investors are turning to products that will hedge against that risk. "There's good money to be made with inflation-linked bonds, although it's been a crowded position," he says.

Rates worries

A bigger worry looms over Latin debt, however: the possibility that interest rates in the US rise more sharply than expected as the economic recovery in the north gathers pace. That prospect is already taking the shine off long-dated Latin debt at tight yields.

Chile, Colombia and Mexico have all issued tightly priced 10 and 30-year bonds in recent months.

While Mexico's tap of a 2044 bond in January, for example, was twice subscribed despite the 4.194% yield on offer, the returns on some long-dated bonds in the primary and secondary markets were simply too tight for some accounts to play.

Says Gutierrez: "We didn't think a 4% yield was attractive for a 30-year bond from the lower-beta names like Panama, Brazil, Colombia, Peru, because we're constructive on the US outlook."

Debt managers wanting to hedge against a possible US rates rise have found another route for decent returns in high beta sovereign paper over the past 12 months.

Several governments have taken advantage of the global chase for yield to stage returns to the bond market. Fund managers have not seen value in all of them.

Bolivia's reentry to the debt market in October with a 10-year bond yielding 4.875% was too much for some - although there was heavy subscription for the deal.

In contrast, Honduras' 2024 bond sold in March offered 7.5% yield.

"Honduras has some challenges, a large current account deficit, high fiscal expenditure, and elections next year," says Finkelstein. "We see more value in Honduras then some of the newer smaller issuing countries like Bolivia."

Venezuela, however, is one sovereign credit that continues to pay handsomely. "This was a very good trade for investors the last few years," says Antin.

"During 2012 Venezuela was an enormous outperformer, returning more than 45%."

Investors who shunned the credit last year because of headline political risk "missed out on one of the best performing credits in the EM sovereign index," he says.

TCW had 2.69% of its Emerging Markets Income fund allocated to state oil company PDVSA and 2.64% to the Republic of Venezuela at the end of 2012, its fourth and sixth-largest holdings.

As for Argentina, says Finkelstein: "one would probably be better served with a legal degree rather than an economics degree to understand its challenges." LF



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