2017 Asset Management Scorecard
Bond fund returns bloom in a volatile year for LatAm
Earnings for bond investors in Latin America have burst into life. The most impressive managers were those who were unafraid to pursue portfolio growth in the thorniest of places.
Venezuelan bonds are cheap, cheap, cheap. That’s because they are priced on the expectation that the country is about to default. And yet, the best bond investors can’t live without them. Several of the 10 portfolio managers topping LatinFinance’s 2017 Debt Investor Scorecard cite Venezuelan bonds as a core driver of returns over the past year.
It has made for a wild ride over the past year, as the country has stumbled deeper into economic and political crisis. But the bondholders who stuck with it were rewarded handsomely when the country and its national oil company PDVSA repaid $2.6 billion of debt in April.
For portfolio managers who can stomach uncertainty, Venezuela is not the only place that has proven to be a winner. LatinFinance’s examination of the strategies of the best-performing bond funds shows that going against the grain has offered some big payoffs. Some nabbed Mexican bonds when Donald Trump was elected US president. Some stocked up on Brazilian paper as the political crisis deepened last year. Some added exposure to oil companies as commodity prices hit rock bottom.
"You really have to be a little bit contrarian," says Luc D’hooge, head of emerging markets bond funds at Vontobel Asset Management in Zurich. The firm’s Emerging Markets Debt Fund returned 8.14% in the three years to the end of March, placing it top of LatinFinance’s Debt Investor Scorecard. "Investors look too much to news, or to things that can change, or to risks. And when they’re worried they make something very cheap. They forget about where the valuation really is," D'hooge says.
The gutsy plays in Latin America come as global emerging market returns have sprung to life after several depressing years. For the most successful managers, it has been a cracking 12 months.
LatinFinance’s Debt Investor Scorecard shows the 10 best performing actively managed emerging market debt funds with sizable allocations to Latin America over the past three years. The funds on this year’s Scorecard have posted impressive one-year returns, deep in double-digit territory. Those returns have lifted the three-year performance to the 6% to 8% range. That represents a sharp turnaround from a year ago, when three-year returns were around half that, and annual returns topped out at 5%.
It is reminiscent of the glory days: One-year returns haven’t been this good since LatinFinance’s 2013 Scorecard.
"Emerging markets have rallied a lot, but they are still good value," says D’hooge, adding that the roughly 300 basis point spread to US Treasury notes makes the asset class forgiving. "You don’t need to concentrate on what happens if spreads come out or go in a little bit. Carry helps you a lot."
As the economic fundamentals improve in Latin America, asset owners around the world are rebuilding their allocations to the region, reversing a multi-year rush for the exit. Late last year, flows into emerging market bond funds finally caught up with outflows over the past three years.
The change of mood gives fund managers a welcome break from drumming up support for emerging markets debt. "Two weeks ago, I was telling clients we expect a rougher Q2 compared to Q1, that there would be more volatility," says Sergio Trigo Paz, head of emerging markets portfolio management in BlackRock’s fixed income group. He cites risk events ahead, such as the French election.
"The clients’ eyes were not like, 'Should I get out?’ They were looking at me with a smile like, 'Good, because I have more money to invest, and this means I can be a buyer on the dips rather than being the marginal buyer at the top.’"
BlackRock’s Emerging Markets Flexible Dynamic Bond Fund returned 7.33% over the past three years, putting it in sixth place on the Debt Investor Scorecard.
A year ago, BlackRock argued that a three-year winter for emerging markets was ending. Now, the asset class is basking in warmer spring weather, Trigo Paz says. "We’re seeing growth and acceleration in some countries," he says. "We think it’s going to be a multi-year reflation. That is very positive for commodity exporters, so Latin America has more to run on that front."
At the same time, as growth in emerging markets accelerates, the asset class looks increasingly appealing compared to developed economies. "This changes the news flow and it changes the perception people have about emerging markets," says Vontobel’s D’hooge. "And that’s a major reason why you see flows going back into emerging markets."
It’s a global trend. "People in Japan are starting to have a more positive view of emerging markets and Latin America fixed income," says Go Ikeda, a senior fund manager at Mitsubishi UFJ Kokusai Asset Management in Tokyo, referring to retail investors who participate in its Emerging Sovereign Fund. The fund returned 7.78% in the three years to the end of February 2017, but dropped out of the Scorecard with final data to end-March. "We have started having inflows."
By mid-April, more than a year of fairly consistent inflows left emerging market bond funds with almost $17 billion more assets to manage than they held in January 2014, according to data from EPFR Global. It has been a sustained comeback. Emerging market debt funds turned a corner in the first quarter of 2016, when their assets hovered some $34 billion below January 2014 figures (see graph).
Yet a year’s worth of inflows have contributed to tighter spreads, notes Trigo Paz. "A lot of money has come into emerging money and more will come. So this means that the reward for the risk you’re taking, eventually, is going to be a bit less exciting than it was. But still compared to other markets, Latin America has more juice."
Between a rock and a hard place
In a year when even the benchmark returned double digits, the recipe for the best-performing funds boils down to dealing deftly with prickly problems. And the prickliest of Latin American bonds may well be those from Venezuela.
Venezuelan bonds have offered among the highest yields in emerging markets for years. As the country’s political framework has weakened, tales of empty store shelves, people going hungry and rising crime have amplified expectations of regime change — and with it, sovereign default.
Somehow, Nicolás Maduro’s government has not just held onto power but also found the cash to pay international creditors, which has confounded bondholders. "Venezuela is a tough case right now because it’s failing to default," says Tina Vandersteel, head of the emerging country debt team at the investment management firm GMO. "It’s been priced to default for several years now, but it hasn’t."
Venezuelan paper offers high returns for the risk taken. But as a staple of the emerging market benchmarks, opting out is also risky because the paper contributes such strong returns. "If funds don’t invest in Venezuela, it means they have to take more risk against the benchmark because they’ll take a bigger tracking error," notes MUKAM’s Ikeda.
Whether or not these tactics change in the future, managers of the funds leading this year’s Scorecard have used a range of strategies in their Venezuelan investments, depending on their views of the risk.
Vontobel has opted for cheap, long-dated PDVSA bonds. "Exposure to PDVSA 2024, 2026, 2027 versus PDVSA short-end bonds makes a lot of sense from a risk management point of view," says D’hooge. "These bonds have lower prices than the short maturity bonds. This means you will lose less money and you might actually make money if the recovery rate is higher than the bond price at default."
NN Investment Partners, whose $4.4 billion hard currency Emerging Market Debt Fund ranks eighth on the Scorecard, similarly has most of its Venezuela exposure at the longer end. That includes Venezuela’s 2027 bond and PDVSA paper with a low dollar price.
"We spent a lot of time adding up the sources and uses of cash flows and monitoring the developments in the country and willingness to pay," says Jared Lou, a New York-based portfolio manager for hard currency emerging market debt at NN, who went to Caracas earlier this year to understand the situation.
"It’s not Syria," he says of the trip. "There are shortages. There are a lot of queues and hungry people. But when I was there, it wasn’t quite the war zone that people expect it to be. The private sector is more vibrant than I would have guessed. A number of high-end restaurants still operate."
When it comes to picking bonds, Lou prefers those without collective action clauses, such as the 2027s. "Trying to predict recovery value on a bond, you’re never going to get that right. Given the high willingness to pay and the fact that having access to international capital markets is so important for this country, we think the Vene 2027s will be treated more favorably than the rest of the curve. We think a lot more activists will be involved in this bond as well."
Others fund managers have taken the opposite approach, buying Venezuelan bonds with much closer maturities. These notes are much more expensive, which means more is at stake in case of default, but the rewards are rich if they pay in full at maturity.
"It’s definitely a nerve-wracking trade," says Mike Conelius, who manages T. Rowe Price’s Institutional Emerging Markets Bond Fund, which comes second on the Scorecard with a 7.7% three-year return. "I’d say you have to look under the hood and you get some more comfort."
A focus on short-dated paper issued by PDVSA, rather than the sovereign, was where the fund found that comfort, he says. "We have enough belief in the short-term ability to pay."
While much of the market looked to longer-dated, low-coupon, low dollar-price bonds, Conelius says he is skeptical about the potential recovery value of such paper after a default.
"The bottom line for us towards PDVSA is the lack of collective action clauses on PDVSA securities," he says. "They would really need to come to the table with bond holders with a palatable restructuring if we ever get there. Lessons were learned in Argentina that a lack of collective action clauses is definitely a benefit you want to take advantage of as bondholders."
GMO, a consistent name on the Scorecard in recent years and 2017’s third place finisher, with a 7.63% three-year return, has also bet on the short-end in Venezuela. GMO’s Emerging Country Debt Fund, however, has found value away from the typical paper. Its largest Venezuelan holding is the more obscure Electricidad de Caracas, according to Morningstar data. The fund holds $84 million worth of the company’s 8.5% 2018 bond.
Piling into oil companies in the middle of a commodities prices crash in another contrarian strategy that offered sparkling returns for confident managers last year.
Pinpointing the nadir for oil prices early in 2016 fed into a successful strategy over the year for BlackRock, says Trigo Paz. "Our investment process allowed us to see that it was a turning point in commodity prices, especially in oil," he says. "We made that call in January when, for the first time, Russia decided to talk to Saudi Arabia. That allowed us to see at least some discussion between OPEC and non-OPEC members."
A similar strategy paid off for T. Rowe Price, says Conelius. Mexican bonds, in particular Pemex’s dollar-denominated debt, was one of the biggest contributors to his fund’s performance last year.
"It was sort of a windfall for us, but I think the ratings agencies did a real disservice to investors," he says. "In the depths of the oil sell-off, the conversation from the ratings agencies was about not really wanting to rate through the cycle, so their ratings would be as volatile as the commodity price." The resulting downgrades of Pemex, "some for good reasons but in some cases not," meant the bonds underperformed before sharply tightening back, says Conelius.
Mexican debt offered another opportunity for gutsy investors. Trigo Paz credits a 2% pickup in total return in November alone to the quick action BlackRock took on the night of the US presidential election. After analyzing strategies ahead of time, the firm was ready to trade on the news of a victory by either Hillary Clinton or Donald Trump. Staff pulled an all-nighter to monitor the results as they came in.
"We called it a pajama party because we’re based in London and at 10 p.m. we were ready to take action," says Trigo Paz.
One play that BlackRock had planned for was what they dubbed Mexit. "Like Brexit," says Trigo Paz. "That was the scenario where we were analyzing the fears of Mexico exiting NAFTA."
With the Mexican peso the only currency that was able to be traded overnight, BlackRock hedged the fund against a potential sell-off. "The Mexican peso lost around 15% that day," says Trigo Paz. "This allowed us to make a significant outperformance, thanks to being short the Mexican peso."
After the US election, "Mexico just got hammered, because of all the rhetoric," says Lou at NN Investment Partners. "In hindsight, it was a screaming buy in November."
T. Rowe Price also highlights its Mexico strategy. The fund cut its overweight by shorting the peso ahead of the election. Then the firm dug into the details of likely policy changes by the new US administration, weighing the rhetoric against what would be politically feasible, before deciding to bet on Mexico after the election, says Ben Robbins, emerging markets debt portfolio specialist at the asset management firm.
"We felt that the election, or the Trump fears, became very overblown," adds Conelius. "So we did add pretty substantially back into Mexico after the election, mostly in Pemex."
Beyond the US election, some found great value in the ultra-long end of Mexico’s curve. D’hooge at Vontobel and Vandersteel at GMO cite the country’s dated century bonds as their preferred instruments. Mexico’s 5.75% October 2110 bond is the single biggest holding of GMO’s Emerging Country Debt Fund.
Calculated on spread duration — that is, the measure of the bond’s sensitivity to changes in its yield over US Treasuries — the bond is by far and away the most compelling, says Vandersteel, who takes an acutely analytical approach to security selection.
Plotting the spread duration of each Mexican sovereign or quasi-sovereign bond in the index against their spreads, it becomes "very, very clear that there is one mispriced bond in the benchmark, that’s just way too cheap," says Vandersteel. "That’s the 2110 bond."
Brazil’s turmoil last year offered another opportunity for investors confident of the country’s long-term direction toward profits.
"Latin America was pretty cheap going into 2016," says T. Rowe Price’s Conelius. "In particular, we entered 2016 substantially overweight Brazil, particularly Petrobras. I was a believer in their deleveraging story, their governance improvement, and that strategy has come through very solidly for us."
Brazil’s economy is finally moving out of recession and perhaps putting the worst of its corruption scandals behind it. "Personally I have a very positive view of Brazil," says MUKAM’s Ikeda, pointing especially to the sovereign’s local currency paper. "The fundamentals are very solid and it has a very high carry. The currency is stabilizing. Even though the Brazilian real fluctuates a lot, if you’re investing in the long term, the impact of the currency fluctuations is limited. The high carry will cover the currency fluctuations."
Others are also keen on Brazilian local currency paper. The 10% January 2021 NTN-F Treasury bond is one of the 10 biggest holdings in T. Rowe Price’s Institutional EM Bond Fund, for example.
The best fund managers have been able to find value in political turmoil and economic routs over the past year, but they still have concerns for the year ahead. Some of that comes simply from the fact that the mood has already improved. "The biggest risk is that there’s less room for error in valuations," says T. Rowe Price’s Conelius. "The fundamentals were getting better and valuations were really attractive 18 months ago, but technicals were bad. There were outflows, there were fears. Now the technicals are good, there are plenty of flows in month-to-month and week-to-week. But valuations are pretty full."
Above all, fund managers cite commodity prices as offering potential risks. "The thing about Latin America as a region is that it’s still very commodity intensive," says Lou, who points to a crash in oil prices as an area of concern.
Vontobel’s D’hooge says while he doesn’t expect a commodity implosion, lower prices remain a risk because of the difficulty in predicting such things. He also points to a sharp reversal in trade relations between the US and Mexico as another risk ahead, although he says he does not expect it to happen.
From a technical point of view, as asset owners place more and more cash into emerging market portfolios, the opportunities for easy returns wane.
Of course, it’s potential pitfalls like this that make investing in the region fun. "You cannot be neutral on Latin America," says BlackRock’s Trigo Paz. "If you look at the next 10 years, you can’t say it’s not interesting. There’s always something exciting there." LF