Q: What is the history of the fund? How does it differ from its peers?

Stone Harbor Emerging Markets Debt Fund was launched in 2007. It is a continuation of a strategy and a fund that we managed in the 1990s and 2000s under Salomon Brothers Asset Management.

At Stone Harbor, we manage a number of fixed income strategies. Within emerging markets, we manage hard currency, local currency and corporate strategies, as well as blended strategies. This fund represents the hard currency strategy.

A big differentiator between us and our competitors is our discipline to do the leg work every single month for every credit. As portfolio managers, we come up with our monthly individual assessments on the direction of rates, credit and FX over the next 12 months for every credit owned or considered. We have a process that’s not only research intensive, but also includes individuals having to put together expected returns across a number of risk scenarios for each particular investment.

Q: What core beliefs drive your investment philosophy?

First and foremost, the asset class is not well understood, so there is an advantage in doing extensive bottom-up research. We strongly believe that emerging markets debt will be the best performing fixed-income asset class on a risk-adjusted basis. 

We also believe in running diversified portfolios as opposed to investing in one particular credit that’s a significant portion of the benchmark. Our primary focus is risk control and avoiding credit deterioration, so we can have zero weights anywhere in the world, regardless of the benchmark weights.

Q: What is your investment process?

We have primarily a bottom-up approach, where we research all the 65 to 70 countries every single month. That process involves not only reviewing each country, but also formulating return expectations that are consistent with our objective to generate performance for our clients.

Despite being bottom-up managers, we also need to understand the situation from a macro standpoint. At Stone Harbor, we have an Investment Policy Committee, where we examine the direction of risk, inflation, and growth on a global basis. We hold offsite meetings twice a year with everybody in the firm, quarterly meetings, and a monthly in-depth meeting, which establishes the framework of the potential global macro risks.

In terms of fundamental analysis, we review in detail every country every single month. That review also includes countries that may not be part of the index, but may present investment opportunities. Then we come up with individual expectations for the return over the next 12 months. The next step is reconciling the differences and coming up with an overall view on the future of each particular credit.

Once we have done the analysis on the expected returns in a country, we look at relative value of the individual securities. We take a quantitative approach in selecting the cheapest securities.

Finally, we look at the returns for each of these credits. We develop alternative scenarios that take into account factors like commodity price shocks or inflation surprises, and we build bullish and bearish return cases. We take all that into consideration when we put the portfolio together.

We are always focused on generating the best risk-adjusted return, taking the appropriate risks, weighing all of the upside and downside scenarios. Ultimately, the goal is to come up with a portfolio that would not only give investors exposure to a market that is fundamentally cheap, but would also outperform that market.

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

We go to all corners of the universe from an emerging market standpoint. Depending on the opportunity, we may heavily invest in Africa and more frontier markets. We are not tied to the benchmark in terms of country and security selection, so we look around the globe for any opportunities.

We invest only in debt instruments. Right now we invest mostly in hard currency sovereign debts because of the opportunity set. We have exposure to local currency and corporate debt, but it is currently low at about 5.5% in local currency and about 4.5% in corporate debt. At other times, we may have more significant investments in both.

Q: How do you determine the true measure of inflation?

We talk with government officials, the International Monetary Fund and the World Bank to get a sense of what they think about inflation. But we also talk to corporations and pollsters on the ground who do inflation testing. 

To understand the actual inflation rate, we need to visit the countries and the companies to understand exactly what’s happening domestically. In most cases, corporations have more information on the real inflation rate than the sovereigns.

Q: Could you give an example of identifying an opportunity and evaluating its investment merits?

We have been investing in Ukraine on and off for quite a while. After the conflict with Russia, Ukraine lost 20% of its productive capacity. It had an economic collapse and its debt was reprofiled. We entered the market after the re-profiling and we focused on bonds that would allow us to generate some excellent risk-adjusted returns.

We visited Ukraine numerous times, analyzing if it is coming out of the recession, if the new government has sufficient policies in place to increase its debt servicing capacity, and if they have the ability in this environment to make the debt service payments. In the case of a shortfall in revenues, do they have the ability to borrow money to make up for that shortfall?

It is a number-intensive process, where we need to work from a balance sheet and cash flow standpoint. However, in the case of Ukraine, the understanding of politics is also very important. The IMF has been advising them on the steps for improving the credit quality and we have been monitoring the IMF criteria, which included pension, labor, corruption reform, etc. Based on that work, we decided to aggressively overweight Ukraine and we have done that periodically in the subsequent years.

We review the country at least once a month to update the team on the developments. We rotate responsibilities for credit coverage between the portfolio managers, so no portfolio manager would cover the same country two months in a row. In that way, everybody has a chance to work on understanding the country and providing input. Based on that work, we develop our base case return assumption, but also other scenarios for performance under a better or worse growth environment or under a commodity shock.

Ultimately, it was a successful investment for our clients as the bonds tightened significantly and upgrades took place. 

Q: Would you cite another example from a different country?

We have been investing in Argentina for almost 30 years. Our view is that this is a country that should be able to handle a reasonable debt load but was not able to access the international capital markets after a bungled debt restructuring and numerous political missteps.  

We were focused on the new government, mainly in terms of its political will and ability to come to terms with its defaulted best, tackle the fiscal overspending, and implement the reforms needed to bring inflation down. There’s been a period of very high inflation in Argentina because of past policies and a very non-independent central bank. In addition to resolving its defaulted debt issue, the new government initiated fiscal policies to combat inflation, and reiterated its focus on an independent central bank. After the election, the newly independent central bank aggressively hiked rates and the government has been able to re-engage with the international capital markets. That took a great deal of political will and should benefit the country for many years.

Argentina is one of the success stories in emerging markets, which is largely driven by a political change catalyst. In the prior administration, given the missteps, the credit quality deteriorated, and the country suffered.  The new government, with much more orthodox policies and a renewed focus on a sustainable credit profile has turned the country around significantly. While there is still more work to be done, this change has played out very well and is being reinforced at the ballot boxes. We expect both Argentina and Ukraine to be one of the upgrade candidates for the next several years to come.* 

Q: Did you get interested in the Argentinean debt before or after the election?

We have been involved in the defaulted debt several times throughout the years. More recently, we got very involved in the defaulted debt that had not been restructured after 2005. We were buying a lot of untendered debt before the election, but went through the restructuring after the election.

Q: Would you describe your portfolio construction process? 

We do have maximum position sizes on a country level. From a risk standpoint, if we don’t like a credit, we don’t own it, irrespective of whether it’s in the benchmark or not. From an overweight standpoint, however, we typically limit our exposure to 6% above the benchmark. So, our exposure can vary from zero weight to 6% over the benchmark and diversification has an impact on the portfolio construction.

We aren’t involved in quite a big part of the market. Actually, everything we own is based on valuation and our belief that it will outperform the benchmark, the J.P. Morgan EMBI Global Diversified Index.

Q: What is your sell discipline?

We formulate expected returns and establish triggers, which could be changes in the political environment, the ratings, the spread price, or the rates. For example, if we own Venezuela and spreads suddenly widen by 100 basis points, that would be a trigger for an immediate review of the country and for reformulation of expected return scenarios. 

That discipline is a great check not only for negative performers, but also for spotting opportunities. Last year we had almost zero weight in Turkey sovereign credit, but spreads widened and hit our trigger point. When we re-examined the credit, we actually ended up buying a lot, because the credit fell to a more appropriate level. So, the triggers work both ways and they are an integral part of our process.

Not only the price movement, but also the impact on the portfolio may force us to relook at the situation, understand why it happened, and reformulate expected returns. When a particular position has caused a 20 basis point impact to performance either way, we have to reevaluate. 

Q: How is your research team organized?

Our portfolio management team has 13 members in New York City, New York and London, U.K. with average experience of about 24 years. We also have several consultants around the world, but the majority of the work is done by the portfolio management team. 

We are all generalists and we are not divided by regions. That’s important because when I look at a country like Argentina, I don’t compare Argentina versus Brazil, but I compare Argentina versus Ukraine, because they are similar in many respects. When we put together a portfolio, we evaluate a country versus the rest of the countries, not versus another country and its region. That’s a big differentiation. 

Every person on our portfolio management team understands every credit that we own, why we own it, what the expected return is under a number of different scenarios, and what the performance impact has been positively or negatively.

Q: How are Ukraine and Argentina similar?

Both countries are less impacted by hard commodity price shocks and both gone through an important political transformation, although for different reasons. Also, both countries have gone through debt re-profiling. The re-profiling of Ukraine was more recent, while in Argentina it happened over a prolonged period of time, but both countries have come to terms with the debt, and now have a sustainable debt profiles. 

They are both on the path of establishing policies, which will allow them to pay down that debt in a more manageable fashion.

Q: What themes play into your investment thinking?

We always need to have an understanding on the macro picture. Until about 18 months ago, the markets feared the combination of a hard landing in China with very limited growth in the developed markets. That fear caused a huge dislocation in emerging markets and a lot of selling, particularly in local currency emerging markets debt.

But now the monetary impact is smaller than it was 15 years ago. Mexico is an oil importer now and we have more diversified economies in Brazil and Argentina. Of course, in Ecuador and Venezuela oil still is the major theme, but such countries are much smaller parts of the marketplace.

At all times, we have to understand the commodity environment and what’s happening from a commodity price standpoint. We run risk reports every day to see how much exposure we have to oil or other commodities. 

For instance, in the case of Turkey we have a lot of varied debt, including hard currency, local currency, corporate. Although Turkey is an importer of commodities and oil, it will be negatively affected by a fall in commodity prices as a knee-jerk reaction towards emerging markets. That’s an important theme in emerging markets.

Q: How have emerging markets evolved over the last 15 years?

One of the developments is that now most countries are producing reliable statistics on growth and inflation and these statistics are verified through the IMF and the World Bank. There is definitely better management in the majority of the emerging markets, and that’s a big change.

The focus on independent central banks is another huge change that has taken place over the past 20 years. In the early 1990s, every slight move in a currency would have a very profound impact on a sovereign’s ability to service its debt, because they had liabilities in dollars and revenues in local currency.

Now most countries have independent central banks focused on inflation targeting, and the currency is the escape valve. In the old days, the currencies were fixed, while now they are flexible. That’s why despite the currency depreciation in the 2014-2016 period, that escape valve actually helped. 

So emerging markets are benefiting from the focus on inflation targeting by the independent central banks and by the fact that their currencies are allowed to weaken.

Q: How do you define and manage risk?

For us the most important risk is credit risk. Understanding a country’s willingness to service its debt and its ability to pay investors back in a timely fashion is key from a risk standpoint. That’s the front-end issue in putting together a credit portfolio and it comes first. 

On the back-end, we have to understand the unintended consequences of the portfolio. For example, we may have built a portfolio that’s too heavily dominated by oil credits. But the biggest risk is permanent loss of capital and we make sure to avoid that through managing credit risk.