Mutual Funds
Recent articles:
• 'B' shares are second-class investments, 3/11/2003
• Don't settle for minuscule money-market returns, 3/4/2003
• 4 reasons to take shelter in real estate, 2/25/2003
More...
| | Mutual Funds
Fat returns lure investors overseas
What to do when stocks struggle and Treasury yields have dipped to 3.5%? Look at developing-country debt, a maturing market that's producing nice returns.
By Timothy Middleton
Forget your Treasury bonds. At the first whiff of higher interest rates, they're toast. The hot bonds are the sovereign debt of developing countries such as Russia, Mexico and Brazil.
Last week, Lipper announced that Pimco Emerging Markets Bond Fund (PEBIX) was the top-performing taxable fixed-income fund over the last five years. Money chases performance: The funds assets have ballooned to $660 million from $260 million in October.
Mohamed El-Erian, the funds manager, says fundamentals in developing countries have steadily improved, information has flowed from them more freely and U.S. investors increasingly accept them into their portfolios. You put these three things together and you get the sort of performance recognized by Lipper, he says.
Performance is what most equity investors have done without for the last three years. And with U.S. interest rates at 40-year lows, its what bond investors might have to do without over the next three. High single-digit yields from emerging-markets debt are one of the few opportunities todays investors have.
Nevertheless, emerging markets are dangerous, volatile places where institutions are weak, small nations can be jostled by their bigger neighbors and hot money means feast or famine as it flows or ebbs.
Lessons from the bubble
If you look at emerging markets the way tech investors looked at JDS Uniphase (JDSU, news, msgs) in 1999, you could suffer their fate. Its pretty difficult to jump in and make an allocation to emerging markets and then jump back out, says James Martielli, the London-based director of global fixed-income portfolios for SEI Investments.
But if youve got the stomach to embrace the occasional massive default, a la Russia in 1998 and Argentina in 2001, emerging-markets bond funds give you the opportunity to earn significantly higher returns than you can get from most domestic bonds. SEI International Emerging Markets Debt Fund (SITEX) surged an average of 12.5% in each of the three years ended Feb. 28.
Mutual funds investing in developing-markets bonds have returned an average of 6.5% in each of five years ended Feb. 28, beating domestic bonds by 0.2% and domestic stocks by roughly 10 percentage points a year.
Emerging-markets debt looks so good now in part because it looked so bad 4 years ago. Thats when the economic policies of Russian president Boris Yeltsin had driven the country to the brink of ruin and it defaulted on its government bonds.
That was, as it turned out, the time to buy. The Russian collapse created such a financial tsunami that it swamped Long-Term Capital Management, an enormous hedge fund organized by a team of Nobel Prize-winning economists. The Federal Reserve stepped in to stabilize world markets.
Improved credit ratings
The United States had done something similar early in the 1990s with the creation of so-called Brady bonds to rescue Mexico from financial chaos. Named for the first President Bushs Treasury secretary, Nicholas Brady, they lent American backing to emerging markets bonds in exchange for economic reforms.
They were a great success, fostering robust economic growth that in turn enabled developing countries to issue their own paper. Currently, only 15.9% of the foreign-held sovereign debt of emerging nations consists of Brady bonds, according to Lehman Brothers, down from a majority.
Still, that marketplace is tiny -- $1 trillion of outstanding issues -- and a public float of something under $250 billion. Thats about the market capitalization of a single global giant corporation -- MSN Money publisher Microsoft (MSFT, news, msgs).
Small as it is, the marketplace is disparate in the extreme. Some developing countries are rated investment grade, such as Mexico, Poland and South Korea. Most, however, have ratings like junk bonds, or none at all. The worst, such as Argentina, are the equivalent of penny stocks.
Nevertheless, overall credit ratings have steadily improved in the developing world, a fundamental factor in the attractiveness of their debt. Average spreads, or the yield above the risk-free rate of the 10-year U.S. Treasury note, have contracted to less than six percentage points, from eight and more earlier.
A 70% yield?
Last week, the 10-year note was yielding 3.57%, and the average yield on Mexican bonds was 6.69%. Hazardous ones such as Venezuela yielded a 10-point premium, or more. One trader said the market for Argentine bonds was virtually nonexistent, their prices so low that the effective yield was more than 70%, except that in reality, it is zero because of the default.
| Foreign-held public debt of developing nations | | Country | Spread over Treasurys | $ billions | | Total | 5.88 | 210.43 | | Mexico | 3.12 | 46.89 | | Brazil | 10.07 | 37.73 | | Russia | 3.39 | 37.02 | | Turkey | 7.28 | 11.35 | | Philippines | 5.31 | 9.38 | | Venezuela | 10.13 | 8.23 | | Lebanon | 6.80 | 5.78 | | Argentina | 17.41 | 4.36 | | South Africa | 1.75 | 4.05 | | Bulgaria | 2.72 | 3.76 |
|
Notes: As of March 11, for the Lehman Brothers Emerging Markets Bond Index, which doesn't track all such bonds. Spread is yield premium above 10-year U.S. Treasury note, which yielded 3.57% on March 11. Dollar amounts include Brady bonds and other sovereign debt.
Source: Lehman Brothers
Country by country, efforts by the United States and the International Monetary Fund have been so successful that recent basket cases like Russia have become showcases. President Putin has exorcised Yeltsin cronyism and instituted serious changes throughout the economy.
I really like Russia, says Tom Cooper, manager of GMO Emerging Country Debt III (GMCDX), which has surged 18% in each of the last three years. Its a good credit. I think spreads are too wide there. The economy is doing well, and its a big oil exporter. Look at the price of oil; they are on the right track from an economic reform point of view.
Wide spreads, or high premiums over Treasury rates, may be too wide in Brazil, as well. That populous nation rubs shoulders with two of Latin Americas economic pariahs, Argentina and Venezuela, and recently elected a populist, Luiz Inacio Lula da Silva, as president.
But the actual steps he has taken so far have been moderate, and many emerging markets portfolio managers are optimistic he will continue to drive Brazil down the road toward economic integration -- and uninterrupted service of its debt. One Wall Street strategist has termed Lula a financially principled populist.
Weve been surprised to the upside by the new government in Brazil, says Nathan Sandler, co-manager of TCW Galileo Emerging Markets Income I (TGEIX), which has spurted an average of 14.1% in each of the last three years.
Interest in an implosion
Even Argentina, which has imploded so violently that it has gone from being Latin Americas most prosperous nation to one where the poverty rate is pegged at 56%, is beginning to attract some interest.
Mike Conelius has been adding to Argentine positions in T. Rowe Price Emerging Markets Bond Fund (PREMX), up 10.5% on average for each of the last three years. When everyone has thrown all hopes of credit out for the foreseeable future, theres always cause for optimism, he says.
In coming elections, he expects Carlos Menem to return as president. Hes the downside, but in fact, hes the best of the bunch. I think after the new elections, people will look at Argentina with a slightly different perspective.
Already, U.S. investors are looking at emerging-markets debt from a different, and more favorable, perspective. The developing world is genuinely developing. Investment firms report that institutions such as insurance companies and pension funds are boosting their commitment to the asset class to 10% or more of their total fixed-income exposure.
SEIs Martielli says a bond portfolio that is 80% investment-grade bonds, 10% junk bonds and 10% emerging-markets debt has roughly the same overall risk as straight investment-grade bonds, with the additional benefit of, at the longer term, an expected higher return.
In an era of 3.57% Treasury yields, higher returns cant be expected -- they have to be sought. Emerging-markets debt is a fertile place to look.
At the time of publication, Timothy Middleton didnt own any of the securities mentioned in this article. He is writing a book for John Wiley & Sons on Pimco and its chief investment officer, William H. Gross.
|
