By Hillary Jackson
Investing in emerging-market debt is not for the risk averse in the best of times. But in a year in which developed markets have gyrated wildly and Greece has found itself hovering on the brink of defaulting on its sovereign debt, even the most seasoned and committed of investors have been rattled.
When worries about Greece reached an apex in early May, the JPMorgan Emerging Market Bond Index suffered its biggest loss since the height of the financial crisis in November 2008. The index lost 1.20% on May 6, the biggest one-day drop since Nov. 12, 2008, when it fell 2.70%.
The yield over U.S. Treasurys on emerging-market debt was high through mid-June, as investors remained spooked about the fiscal situation in Europe and beyond. Many managers of emerging market debt funds posted losses, with the AR Latin American Debt index falling 0.71% in May.
Emerging-market debt had been a solidly performing asset class before the crisis, as investors disillusioned with Western economies found themselves drawn to the higher yields and increasingly attractive risk levels offered by some of the more liquid emerging markets. But fears over problems in the euro zone have cast a pall over the party, at least for now.
Some hedge funds that invest in emerging-market debt have shifted their focus to other parts of the world. Others have homed in on opportunities created by the euro-zone crisis. But nearly all have become hypersensitive to risk, to an even greater degree than usual.
“Risk doesn’t mean that you shouldn’t be involved in the market,” says F. Erich Bauer-Rowe, managing director and co-head of global emerging markets at Jefferies & Co. But it does mean shifting your portfolio from time to time. In many cases, it has meant exchanging high-yield for high-grade credits, a flight-to-quality trend that has played out across the debt markets and certainly in emerging-market debt.
“The worrying position in Greece has caused us to reduce risk—both balance sheet and outright directional risk—as we wait for calmer market conditions,” says Paul Crean, chief investment officer of Finisterre Capital in London.
Finisterre, with just over $1 billion in total assets under management, runs three debt funds, including the $635 million Finisterre Global Opportunity Fund, which returned 4.8% through May after a loss of 2.47% that month and which gained 35.6% last year, according to sources. The firm also runs the $250 million Finisterre Sovereign Debt Fund, which had returns of 3.4% through May after a 3.58% loss that month and a gain of 50.9% in 2009, and the $208 million Finisterre Credit Fund, which returned 45.5% in 2009 and 7.37% in 2010 after a loss of 1.13% in May.
The firm this year started a feeder fund for its three existing funds with $250 million from the $132.6 billion New York State Common Retirement Fund.
After suffering losses earlier this year on Russian basis trades as spreads widened more—and more quickly—than Crean anticipated on the back of regulatory uncertainty throughout Europe, Finisterre has changed its focus to markets and positions it views as having more potential to be profitable.
“Emerging-market bonds sold off as funding problems surfaced in the markets and as buyers effectively went on strike in light of the market turmoil,” according to Crean.
When U.S. Treasurys rallied on the back of the widespread flight to quality, spreads widened. “Normally, one would see CDS contracts widen to reflect these moves, but investors were concerned about putting these positions on, given the highly uncertain regulatory environment,” he says, pointing to German chancellor Angela Merkel’s ban on naked short-selling in May and threats from other European nations to follow suit as the main cause of uncertainty.
In the end, no other country has followed suit, and Merkel’s move is seen as a politically motivated one, but Crean maintains it caused an initial panic in the market and that nervousness surrounding the regulatory environment in Europe remains.
Finisterre’s losses occurred when Crean misjudged how far spreads would widen on five-year CDS, particularly in Russia. Over the course of the year leading up to Merkel’s ban, the five-year CDS-Russian bond spread narrowed from 100 basis points to 15 basis points and then back to the 85- to 90-basis point range in the space of just a few days, he explains.
“I got caught; although the book was structured slightly short on the thinking that basis would widen a little bit, we didn’t expect it would give up nearly everything,” he says. “It was this combination that caused basis to widen.”
Before Merkel’s ban, Finisterre closed out short positions in five-year CDS contracts on German bunds. The firm maintains short positions in Polish five-year CDS, which Crean says is a proxy short for the euro zone. “We still see Europe as a region that will underperform the recovery that is going on in other parts of the world,” he says.
Elsewhere, Finisterre is long Boden 2015 bonds. Boden bonds are federal bonds issued after the 2002 default in Argentina.
“These are U.S. dollar-denominated (domestic) bonds, and this particular bond is a large and liquid—$5.8 billion—issue that was yielding close to 15% in a country that has 6% GDP growth, and is moving toward resolution of its debt holdout problem,” Crean says.
A holdout problem occurs when a bond issuer is in default or nears default and launches an exchange offer in an attempt to restructure debt held by existing bond holders. “We have temporarily reduced our position as yields rallied to 13.8% but will look to reload on any weakness.”
Reducing risk is also a theme for New York-based Lazard Asset Management, and that means concentrating assets in quality credits from countries with strong balance sheets, sustainable internal growth and limited reliance on exports to European countries that are suffering as a result of Greece’s struggles, according to Ardra Belitz, a portfolio manager and analyst.
Belitz manages the more than $2 billion Lazard Emerging Income strategy (LEI), which has both offshore and onshore components, and the $396.3 million off-shore Lazard Emerging Income Plus (LEI Plus) strategy. The $1.1 million LEI offshore lost 2.9% in May and has returned 0.9% year to date, while the $430.6 million LEI onshore lost 2.6% in May and has gained 1.1% year to date. LEI Plus lost 4.5% in May and has gained 2.1% for the year.
While Belitz predicts emerging economies will continue to outpace growth in developed nations over the long term, she notes that expectations in the short term have been tempered since the Greek crisis.
“Demand for emerging-market exports deriving from the euro zone is going to be muted, so that is a growth dampener for trade-dependent economies,” she says.
In addition to slower growth, Belitz predicts more cautious monetary policies will come out of much of the developing world. “The next five to 10 years will be more about differentiation between countries,” she adds. “Just to be long the market is no longer sufficient.”
These factors have sent Belitz in search of stability, while she has shunned vulnerable areas. “We do prefer countries that have domestic demand-oriented engines of growth and are not reliant upon exports as the engine,” she says.
Specifically, Belitz has been moving money into India and Turkey at the expense of euro-zone locations like the Czech Republic, which she says is too reliant on exports to other countries in Europe. “We have made a significant adjustment in April to reduce exposure to the Czech Republic,” she explains, maintaining that Lazard hasn’t lost money but is reallocating in favor of better risk-adjusted return opportunities elsewhere.
India’s growth rates are attractive to Belitz, who predicts the country’s growth rate will climb to 8% to 9% in a few years, up from the current rate of 6% to 7%, as the government moves ahead with privatization plans. “Exports as a percentage of GDP are less than 20%,” she points out. “Turkey is a country that has proven its ability to grow strongly, even under the burden of historically high real interest rates,” Belitz adds, calling the nation’s banking system one of the healthiest in emerging markets.
“The economy is poised for very strong growth, and for the first time we’re talking about single-digit interest rates in Turkey. We have invested in inflation-linked bonds in Turkey since the third quarter of 2009; we’re not involved in the nominal bond market at the present time,” she says.
Risk is also a major concern for Robert Rauch, a partner and director of research at Greenwich, Conn.'s Gramercy.
The firm runs the Gramercy Emerging Markets Fund, which gained 40.74% in 2009 and which is up 1.11% this year through April.
Rauch maintains that the institutionalization of the political and economic systems in many of the world’s developing nations has attracted more mainstream institutional players, who are perhaps not paying enough attention to the potential risks of investing.
“The impact of the euro-zone problems precipitated by issues in Greece reminded everyone that there still is risk in the world,” he says.
“Dubai and Greece reminded people there still is sovereign-debt risk and that profligate policies do have a negative outcome. Perhaps this will lead to a cleansing process in the markets that will be positive over time,” Rauch adds.
Gramercy specializes in distressed and high-yield credits and special situations in emerging markets, and Rauch is seeing plenty of investment opportunities as the massive amount of debt issued from 2005 through 2007 comes due and some issuers begin to default. “There will be a new wave of defaults in 2011 through 2014 as debt arrangements mature and need to be dealt with,” he says, pointing to high leverage ratios over the past several years.
“While it is hard to give specific names, the types of pressures we see developing will likely be focused on high-yield corporate issuers in emerging markets. That is not to say that there won’t also be pressure on sovereigns such as Venezuela,” he adds.
Gramercy has been a major investor in defaulted Argentine government bonds and has been working closely with Argentina’s government to resolve the country’s default situation.
The firm also has been involved with the workout strategy for Dubai World’s sukuk bonds issued by commercial real estate subsidiary Nakheel Development. Another area of focus has been the restructuring of Kazakhstan’s largest bank, BTA Bank.
Rauch says Gramercy is now “selectively getting back into” performing high-yield credits. “On the distressed side, we’ve seen a market pullback in May with respect to the performing credit in the market,” he says.
“May was one of the worst months in the U.S. high-yield market, and that was mirrored in emerging markets,” he adds. “While we wait for the market to stabilize and get over the hiccups caused by ham-handed politicians, the environmental issues caused by offshore drillers and the continuing fallout from the euro zone, there are some pretty interesting opportunities on the distressed performing side.”
In Latin America, Gramercy has started to take a look at Venezuela’s sovereign situation and also at Argentine utilities.
In Venezuela, the government is not putting the investment into the oil industry that is required to sustain its production capacity, Rauch adds. “The political rhetoric may be in the process of killing the golden goose,” he says.
This is because the country’s sovereign-controlled oil monopoly, PDVSA, finds itself increasingly less able to generate cash, as Venezuela’s president, Hugo Chavez, has choked off foreign investment and increased the pace of nationalizations in the country, Rauch says.
Venezuela’s inflation is starting to spiral out of control, and the currency has come under increasing pressure, according to Rauch. “All of these issues are impairing the creditworthiness of the country and, while a sovereign default may not be imminent, the level of credit risk is certainly increasing,” he says.
In Argentina, regulated utilities including Transportadora de Gas del Norte and Inversora Eléctrica de Buenos Aires have already defaulted, and Rauch sees the potential for more to come.
He says the firm will look to get proactively involved, in the event of default, in finding solutions that will please both investors and the government.
Nexstar Capital Partners chief investment officer Peter Getsinger is a Latin America specialist who focuses specifically on corporate debt in the region.
The firm’s $150 million in assets is allocated primarily to Latin America, but Getsinger maintains there are attractive opportunities throughout the world’s emerging markets—even in the face of problems in Greece.
“There is an improving sovereign macro credit story as these sovereigns are more readily able to access markets at rates that are very competitive to where old world levels are,” he says.
Despite recent blips and the inherent risks that go along with investing in emerging markets’ sovereign and corporate debt, the sector remains attractive.
“We have a much more fertile environment and a deepening market that exists for emerging-market corporates and sovereigns,” Getsinger says.
The firm’s Nexstar Developing Opportunities Fund gained 19.6% in 2009 and is up 1.07% this year after posting a loss of 2.27% in May.
“We remain long-term believers in the ability of emerging markets to outperform the developed markets, but this never happens in a straight line, and the markets are full of concern at the moment, with reduced liquidity,” says Finisterre’s Crean.
“This has prompted us to take some chips off the table and await easier times. Part of making money is not losing money in difficult times.”
