Q: Could you give us some background information on the fund?
TCW was established in 1971 and manages a broad range of investment products including emerging market related strategies.
TCW made a commitment to the emerging markets area in 1990 through the acquisition of TCW Worldwide Opportunities, a blended EM debt and equity strategy. The TCW Emerging Markets Income strategy (launched in 1994) invests in EM sovereign and corporate debt denominated in hard currency as well as in local currency bonds and EMFX. Since inception, this total return strategy has outperformed its index by an average of 148 bps net annualized. TCW also manages a standalone local currency strategy, launched in 2010, which has outperformed its index every year since inception.
Q: How is the fund different from its peers?
The first distinguishing factor is the experience of the team. The three portfolio managers, Penny Foley, David Robbins and Alex Stanojevic, have an average of 30 years of investment experience. In addition, the team’s sovereign analysts have an average 14 years of policy and market experience. The team’s EM corporate credit team has been in place since the late 1990s, long before the advent of the corporate bond index in December 2007. As technicals have become increasingly important in recent years, the group has added two strategists to focus on shorter-term dynamics in the FX and corporate spheres.
The strategy’s total return, benchmark-aware approach is another differentiating factor. We are comfortable taking large overweights and underweights relative to the benchmark based upon our fundamental views; we do not invest in a credit simply because it’s in the benchmark. We also actively invest in EM corporates (15-50% of the portfolio) and EM local currency debt (0-30%). As the relative value among these shifts over time, our investment strategy allows us to proactively adjust allocations and capitalize on opportunities on a real time basis. The strategy’s active share is typically 70-80%.
Our approach is fundamentals-based with the majority of inputs coming from work our analysts do on the ground. We actively manage duration, but alpha generation is driven primarily by country allocation decisions, security selection and active hedging. Risk management is key to our process.
Q: What core beliefs guide your investment philosophy?
We have always taken a total-return approach. Our goal is to populate the portfolio with the most attractive opportunities among the broadest range of EM fixed income opportunities in each country. Our universe includes EM hard currency sovereign debt, corporate debt, and local currency debt.
We believe in a top-down approach, which focuses on global and country risk, combined with evaluation of specific opportunities and a bottom-up approach, particularly in the corporate space. As mentioned, we don’t invest in a security or country just because it’s in the index, but rather based upon our assessment of fundamental and technical factors and our assessment of relative risk/reward. We are currently invested in only 40 of the 67 countries in the EMBI. Moreover, while we may like the fundamental story of a particular credit, if we believe it is priced to perfection, we will wait for a better entry point. On the other hand, if a country is going through difficult times and we see the potential for a positive turning point, we would look to get involved early to maximize our upside capture,.
Q: What is your investment process? How does an idea become a holding?
Our process is fundamentals-based and driven by primary research. Our sovereign analysts travel to their respective regions 1-2x a quarter and our corporate analysts meet and speak with management teams on a regular basis.
We look to populate the portfolio with securities that have the most attractive risk/reward potential. For each investment opportunity, we create a base case model, and then we stress test key variables to both the upside and downside to quantify the range of possible outcomes. We generally seek to overweight the opportunities where valuations overstate risks, valuations fully discount negative outcomes, and/or market inefficiencies produce the potential for excess returns.
We also regularly monitor broader risk factors, such as commodity prices, interest rates, and Chinese growth. We monitor relative valuations between sovereign, quasi-sovereigns and corporates, as well as between hard and local currency and adjust allocations on a real-time basis.
Q: What are the specific metrics that the analysts use?
Our sovereign analysts measure over 40 individual metrics, which fall into six general categories - economic variables, debt indicators, FX dynamics, financial sector strength, political outlook and structural reforms. Our corporate analysts look at over 30 separate metrics, which fall into the categories of financial strength, operating strength, debt indicators, debt covenants, management evaluation, industry analysis, and competitive positioning.
ESG-related factors are a critical element in our sovereign and corporate analysis. We do not screen for ESG criteria at the outset. Instead, we incorporate ESG factors in our sovereign and corporate analyses only to the extent we believe they will have a material impact on returns or risks. If we believe that ESG risks are substantial or the range of possible outcomes is too broad, we will not get involved.
Q: How do you approach the local currency debt market?
For every local currency fixed income opportunity, we analyze the rates and currency return potential separately and then determine the best way to express our view, whether as an FX hedged rates position, as a rates position with no FX hedge or as a pure currency position.
Our sovereign research analysts forecast currencies and local rates for approximately forty countries for three, six, and twelve month periods and update these forecasts monthly.
Our short to medium term FX views are based on quantitative models and qualitative analysis that focus on: interest rate differentials, potential debt issuance, the near to medium term outlook for domestic monetary policy, commodity prices and the trade-weighted dollar, and relative inflation and global growth rates. We also take into account exogenous factors, such as political risk and structural reforms. We overlay the results of our fundamental analysis with daily monitoring of key technical indicators.
Q: Can you give us some examples that illustrate your research process?
Argentina is one example on the sovereign side. The country defaulted in 2002 and was being run by the Kirchner administration, which pursued heterodox policy for over a decade. We saw potential for political change in 2015, which made us more constructive on the possibility for structural reforms and a return to orthodox economic policy.
When Argentina defaulted, we had no exposure in 2002, even though it represented approximately 20% in the index at the time. When we started to become more positive on Argentina’s prospects, it represented approximately 1.5% of the index. We started to build our overweight in advance of the 2015 election, buying deeply discounted dollar debt.
Our initial investments were focused on dollar-denominated debt, as we expected the new administration to initiate a much-needed devaluation and raise interest rates. Once that occurred, we started to invest in local currency debt. And when we started to see signs of a turnaround in growth, we added corporate exposure. Each asset class presented opportunities at certain points in the reform cycle.
Often when we like a story in the hard currency space, we find that there may be an opportunity in local currency at a later date. Egypt, for example, has had periods of extended political crises. When they decided to sign an IMF agreement, we felt that there was room for spread compression in dollar-denominated sovereign debt. Similar to Argentina, after Egypt devalued, we added local currency debt.
This is why we believe our strategy has been successful. When you examine the totality of the opportunities in a country, it gives you the flexibility to choose the best ideas within each market.
Q: Would you cite an example of an investment in corporate debt?
Petrobras, the state-owned oil company in Brazil, is one example. In late 2014, there were allegations of corruption at Petrobras and other Brazilian corporates involving major politicians. Petrobras spreads over the Brazilian sovereign widened out to close to 800 bps from a pre-crisis level of 100 bps. At the same time, sovereign spreads over Treasuries also widened as the growth potential for an already struggling economy declined.
Petrobras started to trade as if it were going to default. We felt that as a critical state-owned company, the Brazilian banks would serve as a backstop, if absolutely needed. Furthermore, and importantly, we saw the potential for fundamentals to improve, suggesting that spreads were mispriced. We believed that the market was ignoring the fact that the company’s new management team would take appropriate measures to ensure financial liquidity and longer term viability through, for example, asset sales and a reduction in capital spending. We scaled into our position, and it became one of our larger drivers of outperformance in 2015 and 2016.
Q: How have emerging markets changed over the years?
The MSCI Emerging Markets Index used to be comprised largely of commodities, telecoms and banks. Now, approximately one-third is in IT. Asia is an important part of this growth, China in particular. As countries move up the value chain, they diversify their economies and the investable sectors expand.
In the 1998 crisis, close to 100% of external sovereign debt was denominated in dollars, and the bulk was in Latin America. Today, with the growth in local market, about 75% of sovereign debt is denominated in local currency. And the number of countries has increased to 67, with Africa the fastest growing segment of the index.
Also coming out of the 1998 crisis, many countries moved from fixed to floating exchange rate systems, giving policymakers the flexibility to let their currencies fluctuate to maintain the competitiveness of their export sectors. In the 1990s, they were forced to pursue pro-cyclical policies and borrow to fund ever increasing current account deficits. In the 2013-2016 period, on the other hand, they were able to improve current account deficits through FX adjustments while at the same time keeping external borrowings under control.
Q: How do you define and manage risk?
We manage credit risk, interest rate risk, and political risk. The security-by-security scenario analysis is an important part of our risk management; for each investment idea, we isolate strengths and weaknesses and create base-case, upside and downside outcomes. We also focus on diversification, whether by country, issuer, sector, etc. Liquidity is key, and we manage position sizes and tend to pass on smaller new issues that do not meet the minimum size requirements of the index. We actively hedge portfolio and individual-security risk, using a range of hedging tools, including CDS and currency forwards/options.
We sit down weekly to discuss performance attribution by sector (hard currency sovereigns, corporates and local currency). Our goal is to better understand the drivers of performance, what we may have missed, and determine how we may want to reposition the portfolio.
Q: What is your view on the varying policies in developing economies?
Policymakers are similar everywhere – emerging and developed economies. Populist candidates, such as Hugo Chavez in Venezuela or Kirchner in Argentina, will last as long as they can but, ultimately, the imbalances they create work against them and changes inevitably occur. These changes typically offer investors interesting alpha generating opportunities (the so-called turning points we talked about earlier).
Q: What is your outlook on Emerging Markets debt?
We are constructive on Emerging Markets in light of improving fundamentals, attractive relative value versus developed markets and supportive technicals. The synchronous global growth story continues, which directly benefits Emerging Markets through improved trade and a stronger commodity price environment. In addition, the growth story has been broad-based, rather than concentrated in a small number of countries.
Growth potential for EM sovereigns is also significantly ahead of developed markets with the spread between EM and developed market (DM) growth likely to increase for the second year in a row. With average yields of 5-6% (and the potential to capture more in select markets), valuations remain attractive versus developed markets, particularly considering that close to 60% of global fixed income trades below 2%.
Furthermore, most investors remain underweight EM. We expect technicals to remain supportive in light of this underweight, and continue to see investor interest to add exposure to the asset class.
