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The extraordinary volatility in global markets over in recent weeks has forced investors to adjust their risk assumptions.With concerns over long-term prospects for the U.S. economy, credit contagion in the European Union and the pace of recovery from multiple disasters in Japan, risks in the emerging markets have taken a backseat in media narratives, despite the massive increases in allocations to the space over the past decade.
One portfolio manager who is keenly aware of these risks is Luz Padilla at DoubleLine Capital, whose Emerging Markets Fixed Income Fund has achieved an enviable trailing one-year performance of 10.05 per cent, versus a Bloomberg peer average of 7.25 per cent, with a volatility score of less than half the peer average and a Sharpe ratio of 3.2, compared with 1.2 for the group.
Padilla joined Los Angeles-based DoubleLine in December 2009, along with her teammates Mark Christensen and Su Fei Koo, as part of a talent exodus from TCW Group to join the new firm founded by Jeffrey Gundlach and Philip Barach. They hit the ground running, with separate accounts opened almost from day one, and launched their fund in April of last year.
Padilla moved from the state of Coahuila in Mexico to Escondido, California, with her family when she was 11. She earned a BA in economics from Stanford University and an MBA from the University of California, Berkeley, before joining TCW’s emerging-markets group in 1994. Rising through positions as a research analyst, trader and portfolio manager, Padilla became head of the group in 2006. During her tenure as group head, the TCW Emerging Markets Income Fund produced returns of 36.2 per cent, or an annualized 10 per cent, versus 25.8 per cent and 7.4 per cent, respectively, for the J.P. Morgan emerging-markets global diversified bond index for the same period.
Although the media attention paid to DoubleLine over the past year has been intense, Padilla has kept a relatively low profile while focusing on less-appreciated sectors of her space. She spoke with Institutional Investor Contributing Editor Andrew Barber recently , detailing her current risk-adjusted view of the emerging debt markets.
Institutional Investor: With yields approaching historical lows in the U.S. in the wake of the Standard & Poor’s downgrade, European sovereign volatility remaining pronounced as the crisis there grinds on and dimming forecasts for global growth, fixed-income investors are facing a dilemma when looking at less-developed economies. Emerging markets present seemingly attractive growth opportunities, but longer term, history has seen tremendous volatility in that space during periods of global stress. How do you see the risk horizon shaping up in your markets?
Padilla: Well, in answering that, it’s important to look where we have been. Back in the mid-’90s the emerging markets were not delivering on their promise; growth rates were unpredictable, and they were subject to boom-and-bust cycles. Over the last decades we began to finally see them deliver on that promise, and for the most part, that is because the leadership of these countries changed for the better. Granted, they were helped by the commodity cycle, which made some of their choices more palatable. However, stronger policy mixes also took these countries in a whole new direction. Their underlying credit metrics became significantly stronger, and as a result you saw a whole host of sovereign and corporate rating upgrades, transforming our space from a high-yield asset class to an investment-grade asset class.
This is a secular improving credit story, and we believe that it will continue based on the advantages of these economies, including young populations, extensive natural resources and significant FX reserves. We believe that these economies will continue to deliver further credit improvements.
But despite these improvements, isn’t there still a concentration of risk based on perception of the space? In other words, how can you diversify risk in a scenario where these economies are lumped together by investors?
This is important. I think what differentiates us from our competitors is that from the beginning we have never seen emerging-markets debt as a sovereign-only story. That’s certainly where we came from, but we quickly recognised that there were other sectors in this asset class that could be exploited.
We have always looked at the corporate sector, which has now developed into a robust market, and the local currency sector. So when you look at the history of our investments, we have always been free to use all of the sectors of our market. We are not shy about shifting into any one of those if we feel it offers the best risk-adjusted returns. At this point in time, we believe the emerging-markets corporate sector offers the best risk-reward mix. That is where we have the bulk of our allocation. This leaves our positioning significantly different from a large part of our peer group.
What are the typical spreads you are seeing in that space?
It’s very dependent on which portion of the credit spectrum you’re looking at for the differential and if the bonds are dollar-denominated. That differential for a dollar-denominated investment-grade corporate credit relative to the underlying sovereign could be anywhere from 100 to 200 basis points; on the high-yield side, it could be 200-plus.
So by tilting heavily to corporate credits, you capture that premium while diversifying your policy risk exposure.
Understand that there are certain corporate credits that we are investing in not only because we like the underlying fundamentals but also because we think they have the potential to move up the ratings spectrum. As a result, we think that differential to sovereigns can compress. We have credits in Brazil, for instance, that are either investment grade or just below in the ratings spectrum that are trading significantly wider than Brazilian sovereigns. We think there is the potential for these credits to get closer to not only the sovereigns but also to their global peer group.
This is important because one of the key trends we are now noticing in emerging markets is that corporate credits from some of these nations are starting to find their way into what are traditionally thought of as developed-market indices. The Merrill Lynch and J.P. Morgan corporate index families are 10 to 12 per cent and 7 to 8 per cent emerging-markets credits respectively . What that tells me is that there is a significant and growing interest in the debt of companies domiciled in these countries. They are transcending to what are typically thought of as developed markets and being used in indices that are benchmarks for other sectors of the fixed-income markets. This is important because this exposes these credits to an audience with deeper pockets than those of traditional emerging-markets investors. That bodes well for both the stability of pricing and the potential for further spread compression as the emerging-country premium is no longer placed on these bonds.
This doesn’t mean that all emerging corporate credits have an attractive risk-reward profile. For instance, we have avoided Chinese high yields generally and the real estate sector there in particular. We feel that China is a place where transparency has not improved to the same degree as it has in other countries. We have limited our exposure to these credits overall as a result.
But is there a point when a troubled situation can become attractive on a value-to-risk basis?
Perhaps, but there are certain countries that we just wouldn’t touch. Venezuela is a country that we are very concerned about because of the leadership. We understand that it’s a place where you are certainly being well compensated for being there, but because we are not boxed into holding sovereigns, we can pursue similar returns in the corporate space that don’t carry the political risk. It certainly doesn’t seem out of the realm of possibility for Hugo Chávez to stop making payments on his external debt. That may not be a high-probability event, but it’s certainly a “some-probability” event.
In addition to your corporate focus, you also seem heavily biased toward dollar-denominated debt, which seems to be somewhat counterintuitive given your overall view of the space.
One thing that I am constantly asked about is why we are not invested in the local currency markets. When the U.S. dollar began to decline and the U.S. financial media was filled with people who were bearish, the very first thing we heard from policymakers in emerging economies was a clear message that they did not want their currencies to appreciate any further. As a result, the local currency risk-reward ratio there became skewed, leaving you with all the risk but having potential rewards capped. Those are not the type of opportunities that I want to go into. When you think about the macro picture, about the potential for a continued slowdown in global growth and how policy makers will react to maintain competitiveness, I see the local currency sector as the most vulnerable.
When we look at current returns on local currency funds, which have generally been underperforming with higher volatility profiles, it’s clear that the risk-adjusted returns there are less attractive.