Emerging-market bonds were the best-performing fixed-income category in 2003, gaining nearly 31%. Leading the pack was Mohamed El-Erian, who manages the PIMCO Emerging Markets Bond fund (A-rated on the BusinessWeek Mutual Fund Bond Scoreboard) and oversees $12 billion in emerging-markets debt. His strict approach to diversification has rewarded his fund handsomely -- it's up an annualized 22.6% over the past five years. BusinessWeek Associate Editor Toddi Gutner recently caught up with El-Erian for phone interview. Edited excerpts from their conversation follow:
Q: What's driving the strong returns in emerging-market debt?
A:The U.S. used to be the only engine for growth. Now, China is helping along -- but it's a very different process. China's growth process is very commodity-driven, and commodity-based economies and commodity prices are soaring.
What's more, you have improving credit ratings in the [emerging-market] countries. Five years ago, 95% of the emerging-market nations were junk-rated. Today, more than 50% of the group is investment grade. We sense a continued long-term climb up the quality scale. That's a perfect world for emerging markets.
Q: What drives your investment philosophy and consequently your stunning returns?
A:Country differentiation is important. We aren't shy about staying away from some countries and being aggressively invested in others. What's true for the asset class as a whole is not true for all countries. Even when we invest in those countries, there are still a lot of market imperfections.
We try to exploit imperfections for our clients rather than get hooked by them. We do daily credit exercises. We also have long-term structural positions. Once we have those, we continuously look for the best value. Country position doesn't change much, but within the country, it may change.
In addition, even though we're an emerging-market boutique, we're part of the PIMCO platform. We get insight from other managers on interest rate trends in the U.S. Our main added value comes from the way we manage the interest rate risk. The other half is getting the interest rate call correct. That helps us to be in the right instrument in the right country and get the currency right.
Of our three-year annualized returns of 25%, about 13% comes from the asset class, and the 12% came from our country selection.
Q: There are some real risks to investing abroad, including the possibility that investors will become wary of financing growing current-account deficits in the emerging markets. How do you manage risk in your portfolio?
A:We use a matrix approach. The portfolio is divided into three analytic categories, or buckets: the Anchor Bucket, the Return Bucket, and the Intensive Care Bucket.
The Anchor Bucket is comprised of investment-grade countries that are most stable in terms of credit but very sensitive to U.S. interest rate risk. Countries in this group include Mexico, South Africa, Chile, and Tunisia.
The Return Bucket is what I call the engine of the portfolio. These are much higher-yielding credits and much more volatile. Countries like Brazil, Ecuador, Ukraine, and Peru are part of this universe. The main risk element in this group has to with credit developments, so we look for changes daily. While the first category looks like fixed income, this one looks like equity.
Finally, there's the Intensive Care Bucket. These include countries where the main risk isn't interest rate or credit risk, but rather default risk. We shy away from them entirely. Argentina, Uruguay, and the Philippines are examples of Intensive Care credits.
It's important to note that these categories are dynamic, which means the countries are constantly moving between buckets. Russia is now in the Anchor Bucket, and Argentina is in the Intensive Care bucket, but five years ago, the opposite was true. It's really important to get classification right but also to note the changes in the countries' credits.
Q: How do you choose securities?
A:We measure three things: Is [the security] cheap relative to a country's yield curve? What credits are cheap, and what are expensive? Why is it cheap or rich? Then we ask whether the answers to these questions are for a good or bad reason. We also look at whether or not there will be new issuance and which part of curve will they issue.
We have long-term structural positions. Once we have that, we continuously look for the best value. Country position doesn't change much, but within the country, it may change. We're also driven by the JP Morgan Emerging Market Bond Index (EMBI ), though there are times we will take steps away from the index.
Q: What countries do you find attractive, and why?
A:Brazil is the best value out there. It represents 20.4% of the JP Morgan Emerging Market Bond Index, but 28% of our portfolio is in this country's debt. We've been overweight the index for 18 months. It's a single-B credit, and we think it will be investment grade in two years.
We also like Russia, which is benefiting enormously from the sharp increase in commodity prices. It's also running a budget surplus. It represents 5% of the index, while we're overweighted at 15%.
Other countries we like are Ecuador (we hold 2.89%, vs. 1.4% for the index), Peru (4%, vs. 2.3%), and Panama (3%, vs. 1.8%). All of these have improving country fundamentals. We're also invested in Tunisia (2.3%, vs. 0.3%) and Ukraine (2%, vs. 0.9%).
Q: Are you're avoiding some countries? If so, why?
A:Capital preservation is more important than index weightings. Even though Argentina is 2.37% of the index, accidents do happen. In 2001, Argentina lost 65% of its value. Even now, at 28 cents on dollar, we think it's still too expensive and too high a default risk.
We've stayed away from Uruguay, which we think could fall by 50% in value. That makes it a high default risk. It's currently 0.9% of the index, but we have none of its debt. Political instability makes the Philippines unattractive. We believe the election will contaminate economic conditions. The index holds 4% of Philippine debt, while we don't hold any.
Some countries are too expensive. A lot of people betting on possible entries into the European Union, and investors have already priced that in. We don't think entry into the EU will be as smooth as they are priced. Examples of these countries include Hungary, which is 0.5% of the index, but we have none. We're looking for entry points down the road. Poland is also too expensive. We have 0.1%, vs. 1.27% for the index. We're also underweighted in Turkey (1%, vs. 5.8%) and Venezuela (1%, vs. 4%)
Q: How have you positioned your portfolio for a rise in interest rates?
A:We have positioned ourselves for the reason why the interest rates are going up. The reason: global economic growth. We've reduced our interest rate risk by shortening our duration in the interest rate risk bucket [the Anchor Bucket].
Relative to the index, we're six months under, and six months over the index for credit risk. That's because I'm looking for a credit that benefits from the growth in the global economy but doesn't get hurt in the sell-off in U.S. interest rates.
Overall, I'm reducing interest rate sensitivity and increasing credit sensitivity. A rise in interest rates would hurt this asset class when the increase is not due to global growth but due to a disorderly collapse in the dollar and an unwillingness of foreigners to finance the growing current-account deficit. I think there's a low probability to this scenario. But to protect my shareholders, I invest in bonds that are easily traded.