Q: How has the fund evolved since inception and how does it differ from its peers?

The fund is based on the Emerging Markets Blended Debt strategy, which was launched in 2004. I have been the lead portfolio manager of the strategy since inception. The objectives and the philosophy have stayed fairly consistent as we developed mutual funds from our institutional product. 

When we launched the strategy back in 2004, we had a solid institutional footprint in both emerging market sovereigns and corporates. However, there was no corporate or local currency index at the time, and most investors were managing against the EMBI+ or the EMBI Global, so we chose the most diversified benchmark, but maintained a broad opportunity set, knowing that if we avoided sectors such as local currency, we might underperform our peers. Our peers were very involved in local currency, but few were investing in EM Corporates, which our firm had been investing in since the 1970s. That’s the first differentiating factor for this strategy. 

More importantly, our firm has a deep underwriting culture.  Our team was founded in 1997 to invest and manage emerging market debt in both sovereigns and corporates on a dedicated basis.  That makes us one of the institutions with the longest corporate debt experience in emerging markets. So, from the very beginning, the fund has invested in both corporates and local currency, and we understand the liquidity and volatility dimensions of these risks. . 

That approach has allowed us to stay competitive and true to bandwidth considerations. We aim not to stretch ourselves too thin as the marketplace has grown in terms of number of issuers, economies, core countries, and high yield corporate. We have actually specialized and grown with the marketplace, and have been well rewarded for that. The number of sovereign debt issuers has grown dramatically over the past 2 decades and the number of companies has proliferated as well. We have split our universe into sovereigns and corporates at the PM level and together with my co-PM Anupam Damani we manage over $12B on a combined basis.  

The mutual fund, which has three class shares, was launched on September 29, 2014, to expand the customer reach to the end retail market. This fund, within the same composite as the strategy launched in 2004, manages $350 million assets under management. Together, with my partner, we manage over 15 distinct strategies with a range of mandates, including a large portfolio for TIAA’s insurance company. All strategies exploit the unique opportunities within the EM universe, but they range in terms of risk appetite, some of which focus exclusively on high yield, local markets or corporates.

Q: Which part of the emerging markets do you primarily focus on?

In the mutual fund, we focus on the debt space, including sovereign, corporate, and agency, but we occasionally do credit default swap, or CDS. We can hedge our local currency exposure, but we tend not to. We don’t do foreign exchange or FX trades as a discrete investment strategy yet. When we take a currency view, we exploit it through a bond instrument. When we invest in Brazilian local markets, we buy the government debt and do not hedge out the currency, which would lower yields since there is a cost to hedging. That said, unhedged local currency risk has a higher degree of volatility and has a higher risk charge than a hedged investment. 
 
We don’t focus on any single region. We have always been involved in frontier markets, which is a subcomponent of the emerging market index. We don’t shy away from smaller, or more exotic countries, if they offer value, or if we find a good investment theme.

There are more than 67 countries within the EMBI Global Diversified index. We certainly don’t invest in all of them, but we need to know them, and that’s embedded in our process. It doesn’t mean that we buy each market, but we research them. In Tajikistan, for example, our sovereign team concluded that the country wasn’t providing enough value for the profile it exhibited.

In the corporate segment, where I am the Sector PM, we tend to be more focused on the core markets that have grown up over the years. Countries like Mexico, Turkey, India, Colombia, Peru, or Chile are developing creditor rights framework and are certainly not perfect, but they are more established and their financial and monetary institutions have certainly improved. Once more orthodox financial policy is adopted at the sovereign level, we start to delve into the corporate opportunity set to find additional sources of alpha. 

Overall, we are very sensitive to receiving the appropriate spread for the country risk and in getting additional spread to compensate for corporate credit risk as well. I believe that, if we get the credit call right, we are able to find higher yielding corporate credits that can deliver better risk adjusted returns over the long run than the generic EMBI GD index. .

Q: How would you describe your investment philosophy?

Emerging market debt is heterogeneous, ranging from investment grade to distressed, and provides attractive risk-adjusted returns for the long-term seasoned investor willing to do the credit work. As much as we think that emerging markets are attractive in terms of their return potential, we believe that we should be compensated for the risk of less mature institutions, and for EM corporates, generally, we need higher yields compared to comparably rated developed market corporations as compensation for the “zip code” risk. Within some segments of the markets, such as frontier issuers and high yield corporates, there is also a liquidity dimension, so that is factored in to the investment thesis. At both the corporate and the sovereign level, we do expect a liquidity premium when we invest in less liquid instruments. 

With respect to allocating to local markets, which are often more liquid in terms of bid/ask pricing, there is the FX issue. If we buy FX unhedged, the allocation would be completely out of benchmark, and we need to be very conscious of the risk budget. As the lead portfolio manager, that allocation to local currency markets can have a dramatic impact on performance versus the benchmark and the peer group. Volatility dynamics need to be monitored carefully. We need to determine when the flows are going to be supportive, when the allocation will to add positive alpha, and when it is going to detract heavily.

For example, during the financial crisis we exited the out-of-benchmark local currency sector altogether, because we felt that the additional risk was not going to generate positive alpha until the developed markets had stabilized. While we reduced our non-benchmark corporate allocation, we did not exit completely.  Still, I have to be willing to take on non-benchmark corporate credit risk, which is highly correlated to the sovereign market. 

In periods of market stress and liquidity breakdown, I need sufficiently higher returns to compensate me for the lack of liquidity in corporate credit. There are some corporate bonds or quasi-corporate bonds that trade as actively as sovereigns, like Pemex in Mexico and Petrobras in Brazil but, typically, the sovereign market tades about 4 times as much as the corporate market in terms of flows.  Evaluating the global macro backdrop is crucial to our investment stance in terms of risk usage and positioning, and it is extremely important to have a view on how developed markets are behaving and how that translates down into the emerging markets, which are much smaller though growing in absolute market capital terms. 

In general, I believe that there is a broad spectrum of return and reward opportunities in the marketplace, but you have to also be very cognizant of the risks. We believe that each channel can deliver opportunities, but intense credit underwriting, relative value analysis, and active portfolio management are the three pillars of our philosophy.

Q: What is your investment process?

We have a top-down, bottom-up process, with a global macro overlay. Emerging markets are growing in terms of GDP, and we can expect debt to grow as well. Right now, however, the market is smaller and less actively traded than the developed one. It is a longer-duration asset class than high-yield or investment-grade credit and that’s why analyzing and having a view on U.S. rates is critical. We need an understanding and a view on duration and trading flows, to know whether the market is being supported, to decide if we should act more defensively, and how much to allocate to the non-dollar and other out of benchmark components that utilize the risk budget. 

I am responsible for setting the aggregate duration and allocation and I have to be comfortable with aggregate exposures at the country level. Since we started the strategy, we have maintained a diversified portfolio, and we never overconcentrated in any investment theme, such as one country or company. The other issue is how much of our risk budget we are willing to take and how much we want to deviate from the credit quality of the benchmark.

So, we start with an investment view at the global macro level, and then our process incorporates additional steps. We evaluate the sovereign field from a top-down perspective and our sovereign team helps us assess the investability of the universe in any particular emerging market economy. We look at the spectrum of opportunities to see how comfortable we are with the institutional stage of development of the country to determine if corporates or local currency domestic bonds are suitable investment opportunities for the strategy to exploit.

We consider the broad opportunity set, but this investability assessment helps to focus our research resources. For example, we still haven’t invested in Vietnamese corporates or local currency, but we were early investors in the Egyptian pound T-bill market. After the Arab Spring, the country adopted capital controls, we stopped investing in local markets for some time.  As the Egyptian economy has stabilized under Assissi, with other GCC assistance and an IMF multilateral program, enough reforms have been adopted and yields are sufficiently attractive enough for the fund to be involved again. The political environment for Egypt remains very challenging for a longer-term investment thesis, so we have avoided the corporate and quasi-sector where we continue to see a dearth of opportunities or institutional development. 

In terms of security selection and the bottom/up part of process, my partner and I are sector specialists along the lines of sovereign and corporate/quasi-sovereign disciplines. We work with a team of eight research analysts. There are four research analysts, who work on sovereign debt, performing a quantitative and qualitative assessment of the country, which includes understanding the balance of payments, debt sustainability dynamics, credibility of the fiscal plan, etc. to arrive at an independent view of the credit quality for the external debt. The sovereign analysts are also responsible for determining whether or not FX and local rates are attractive. The sovereign PM, my partner, along with the analysts, decide whether the out-of-benchmark local currency opportunities will generate positive alpha.

At the sector level, I am the corporate PM and work directly with the corporate team of four regional analysts, who specialize in underwriting the quasi-sovereigns within the benchmark and a variety of companies. Because each EM country has its own regulatory framework, it’s important that the analysts are experienced and familiar with the countries within their assigned region. They need to evaluate the credit worthiness of agencies to determine if they are viable on a standalone basis or can need government support, and they need to assess the role of key companies and banks, which can often impact the sovereign fundamentals given their relevance and importance.  

It is the discipline of understanding and really knowing our credits, which makes us different. Our analysts can also leverage off of sector specialists across the firm, including equity, or high yield, or investment grade, which gives the corporate analysts additional insights into global trends, challenges, and helps to evaluate the competitive viability of the EM corporate being evaluated. We believe that understanding the local economy dynamics and doing due diligence at the country and company level, gives us a unique insight and advantage. 

The final step of the process is relative value. At that stage, we need to understand if we are getting sufficient return for the additional elements of credit risk, asset type, or illiquidity. 

Q: Do you rely on rating agencies? Can you give is an example that illustrates your research process?

We have our own internal ratings. We look at the external rating agencies, but it is our core principle, that we need to have our own views. The rating agencies don’t always think alike, so we assess credit quality in terms of default probability, ultimate loss given default, and timeliness of debt payment. Although we don’t like to get in and out of positions quickly, we build a view on how we expect the security to perform over the next 12 to 18 months at least. 

Sometimes we can be more optimistic than the rating agencies, and that’s when we buy early when it’s cheap and sell when things have played out and ratings catch up to our view. Alternatively, we may get out of positions when the rating agencies are just starting to flag some of the deteriorating trends.

For example, Petrobras, the Brazilian state-controlled oil company, was rated B3, B+ and BB by Moody’s, S&P, and Fitch, respectively. Petrobras represents a huge quasi-sovereign company, which faced many challenges. We were avoiding the company, because we felt that the price was distorted through policies at the government level, which weren’t initially priced in. While the market and the agencies focused on the corruption and quantitative leverage indicators, our view that the links and importance of the company to the government and the overall economy was a critical part of our investment thesis. 

When Moody’s downgraded Petrobras to B3, we didn’t agree. We felt that the credit was still extremely important to the sovereign and would be ultimately protected. The downgrade made it a very cheap investment, so we exploited the opportunity, and it has been one of our top sources of alpha. 

Petrobras is not in the benchmark, because it’s not 100% owned by the government. It’s part of the CEMBI, JPMorgan’s EM corporate index, but that corporate index didn’t even exist when we launched our initial blended strategy. Nevertheless, we recognized Petrobras was a vital part of the economy and always had a view on the company since the team’s formation. It is good example of different external rating approaches and illustrates the need for an internal credit view.

One of the problems with Petrobras was the local content rule, which prohibited Petrobras to have more joint ventures. The failure of the government encouraged a bizarre kickback scheme and the local political structure made possible corruption of an astonishing degree. Brazil had been net oil importer, so Petrobras was like a source of foreign currency. They also made policy and capital expenditure allocation mistakes because they assumed that oil prices were going to sustain very high levels.

Ultimately, Petrobras was very helpful to Brazil’s economy. It took a different turn and, with a caretaker government, it is on a much better footing by selling assets and bringing in foreign investments. They have definitely done liability management, extended out maturities, and got upgraded by Moody’s from B1 to Ba3. Now most of the ratings are up just a notch below the sovereign and Petrobras became one of our best investment opportunities in a long time.

Q: What is your portfolio construction process?

Our benchmark is the Emerging Market Bond Index Global Diversified, which is 79% sovereign and 21% quasi-sovereigns (unguaranteed 100% owned agencies, which we evaluate on the corporate team). Lately, we have been comfortable with a mix of 50% corporate and 50% sovereign, while the out-of-benchmark corporate bond allocation has been about 30%. These investments are very correlated with the underlying sovereign bonds where they are domiciled but they are often cheaper and offer higher yields for the additional corporate credit risk. We’ve been successful at exploiting the space through assessing relative value, active trading and prudent underwriting.  

Keeping an eye of the risk-adjusted return is an important part of the process. The market is dynamic and, certainly, we need to be able to respond and take actions at an allocation level, but we tend to not be dramatic in our shifts. Not moving too quickly at tactical allocation has played out well for us.  

I am a little stingy with my allocation to local currency, but that approach has been beneficial, because the dollar returns of local market haven’t been favorable. That trend isn’t permanent, so we work with my colleagues, global macro specialists, strategists, and in-house economists, to evaluate the broader level for headwinds that I need to be cognizant of. We also pay attention to equity flows, which can also be an indicator for risk appetite and EM FX trends. 

So, the allocation depends on the spread opportunities and the risk budgeting I am willing to take. Security selection happens at the sector level and is based on the research recommendation, with the PM decision-maker and relative value input from trading.  Our team of 15 is made up of 11 seasoned members with an average of 12 years of experience in EM.  We are always keeping a look out for the things that are really going to add value. Right now, I like BB rated EM corporate bonds, which generally has shorter duration. 

We usually have between 150 and 200 holdings. According to our internal guidelines, an exposure to any country of more than 5% is flagged by our risk management team. Our maximum overweight in any one country is 5% and 150 basis points for out-of-benchmark securities. There is no constraint for benchmark securities, because we want to be able to focus on selection. If I dial down my risk budget, that’s either because valuations are stretched, or because of an exogenous event that may have a negative effect on liquidity.

Q: How do you define and manage risk?

Risk is a multi-faceted notion, but in the context of the portfolio, the key risks need to be managed by a portfolio manager as the first line of defense. In emerging markets, we are used to and have to manage through headline risk, country risk, political risk, and sometimes contagion risk, which the manager shouldn’t ignore.  We are also well accustomed by now to the possibility of sanctions risk, which can be imposed at the country or company or individual level.  Customers need to appreciate that these are risks in addition to FX or duration depending on the mandate.  How those different risks are managed and how we get attractive yield for our investors still comes down to allocation and security selection and we need to get paid for the risks mentioned above.  

Within the risk-budgeting process, we use metrics and analytics.  Although there are many myths about emerging markets, historical risk-adjusted returns have been very good. We spend a lot of time educating internal and external clients who often react to headlines, mapping out and refining our investment thesis, and keeping an eye on events that might potentially shift our views of the market or the region. Emerging markets are just more fluid and have to be justified more frequently.

Importantly, the additional resources at the institutional level are crucial to managing all these risks, which include necessary input from legal and compliance areas. Because of our firm’s size and our EM market presence across strategies, the team gets access to government officials and policymakers, and direct senior management of big companies, which is critical in the due diligence phase and to perform ongoing maintenance of portfolio credits.  For publicly-listed companies, which more and more emerging market companies are, we can exchange information with our equity colleagues about the management and its reputation, which adds yet another input to the security selection process.