Fri, 22 Jun 2012
Morningstar 2011 Fixed-Income Manager of the Year John Carlson says new debt issuance is high in the developing world, with plenty of opportunities in dollar-based bonds and a growing local-currency market.
Bridget Hughes: Hi, I'm Bridget Hughes, one of the mutual fund analysts here at Morningstar. I'm at the 2012 Morningstar Investment Conference, and I'm sitting here with John Carlson of Fidelity. He runs the Fidelity New Markets Income and Emerging Markets funds, and he's done that since 1995 with a fabulous long-term record.
Thank you, John, for joining us.
John Carlson: Well, thank you, Bridget and thank you Morningstar for inviting me. It's my pleasure to be here.
Hughes: So we've heard a lot about emerging markets at this conference, about emerging markets being attractive both on the equities side and the fixed-income side, but it isn't as simple as just piling into emerging markets. There's a lot more to it. So, on the fixed-income side maybe you can talk about how you analyze and handle your interest-rate positioning and your credit positioning, and what other decisions that you have to make?
Carlson: Yes, thank you Bridget. I think that's a very encompassing question to start with. When you're looking at fixed-income markets, of course, interest rates, the term structure, all of that's going to be very important. Then we're looking at credit, as well, because we're dealing with sovereign, quasi-sovereign, and corporate issues, so we need to assess the credit dynamics in which way they're moving. Then finally, of course, we have the currency aspect because we're investing in both local markets and dollar bonds. So there's a lot that goes into it.
For example, last year I took the decision that I wasn't too worried about inflationary rates, so I extended duration. I looked at credit spreads primarily in the corporate market and decided that they were too tight given the relative value and took down the corporate position. And I felt that a lot of the emerging-markets currencies, both in terms of valuation and in terms of flows last year were completely overdone. So I stepped back from local currencies. So yes, there's a lot that goes into building an emerging-markets bond portfolio.
Hughes: Then duration today in your portfolio as you look forward is where?
Carlson: Well, duration is around seven years, so I've scaled back a little bit from last year, but last year if we were here, rates were, at the long end of the U.S. curve, 4.5% in terms of yield, and that's roughly where you are in Brazil today in 30-year debt. So we've come a very long way in terms of that. But I'm in the camp that long rates are going to stay lower for longer just as short rates are. I scaled back a little bit on duration, but I still have not really added meaningfully to either the foreign exchange or corporate credit product at this point.
Hughes: One of the standout characteristics of your portfolio versus your emerging-markets fixed-income index is your stake in Venezuela, and it's been something I think that's worked pretty well for you. Can you talk a little bit about the analysis that went into Venezuela and that you were going to overweight the country, and then where do you go from here?
Carlson: Right, exactly. Well if I step all the way back to 2008. and let me step in for the back, higher level. Venezuela basically is an oil story; 95% of the country's revenues are coming from oil. In some ways it's a simpler story, but then you add in the politics and it becomes more complex.
For me it's always been a valuation story. Given the models we run, looking at different ranges of oil prices and looking out three to five years, we feel very strongly that certainly Venezuela has the ability to service its debt, and that's the first and foremost important point. So then it becomes a valuation story.
Stepping back to '08, Venezuela was trading at distressed levels. So I went overweight at the end of '08, carried that overweight large position through--I think at one point it might have been at around 15% of the portfolio--cut that back to about 8%, again based on valuation, for 2010, added to it last year, and now brought it back a little bit.
It kind of ebbs and flows with the valuation, both absolute and relative. So it is my largest position. Again it's cheap, and given the cheapness and with what we consider to be good fundamentals given the range of oil prices that they could afford to pay, [we give it an] overweight [position].
Hughes: What about the rest of the portfolio? Are there other sort of little Venezuela-type stories percolating?
Carlson: There might be other Venezuela-type stories, but I am not sure I'm overweight, Bridget. So the other areas I really like are I think the whole Eastern European countries, the Hungarys, the Croatias, Latvia, Lithuania; they all have their own local issues. But I think that whole region has been tainted by being new to the eurozone or on the edge of it, in the periphery.
And hence given their credit ratings, for the most part investment-grade with the exception of Hungary, they trade too wide. So it becomes a valuation metric again and again slightly overweight. I really like the two Asian big credits, Philippines and Indonesia, as well.
Hughes: You mentioned for the local-currency part of the portfolio that you had taken that down, and the fund is historically and today is predominantly a U.S. dollar-denominated fund. But as we hear a lot about the race to debase and the problems with the U.S. fiscal situation, as you look long-term from a currency standpoint, does it still make sense to have a primarily dollar-denominated portfolio?
Carlson: That's a question that comes up at least once or twice a day in talking to people because I think [there are] two aspects of this question, Bridget. First, is that this is the oldest fund in the marketplace. It came to market in May 1993. At that time there were only a handful of countries in the dollar index, and local-currency markets were much smaller and much more close. By nature it historically was focused on the dollar debt.
The other aspect, because of its history and me taking over the reins of the fund in '95, we've marketed and sold it that way. Prospectus compares it to [J.P. Morgan EMBI Global]. To me, yes, you'll have the local markets grow, but there is plenty of opportunity on the dollar side. I do use local currency, but I keep that limit to about 20%. I use it tactically along with corporate bonds, distressed debt, and even equities, which are all part of the mix in the portfolio, but I keep two thirds in the sovereign/quasi-sovereign dollar debt.
Now last year, what made me move was that when I looked at through my travels and different modelings that we do, the U.S. dollar just looked completely too cheap. Just everybody was bashing it. Then I looked at the flows into local-currency product; they were massive. At one point, I think half of the Mexican local market was owned by foreigners. You could go through Eastern Europe, Africa, and so on and so forth. It became all one-sided, and you can see what's happened since last October--it was easy to get in, but not so easy to get out. Then you had Brazil and other countries putting taxes on to limit some of those hot-money flows.
Hughes: In terms of new issuance, is it changing such that there is more supply on the local-currency side and that the hard-currency-denominated piece is shrinking, or do you still have plenty of new issuance in both camps?
Carlson: I think there is plenty of new issuance in both camps. A lot of it is roll-over, especially on the local-currency side, so that market continues to grow. And as more asset-based products and liability products are developed in local economies, it is going to continue to grow. That is the growth market.
You've also seen on the hard-currency side really the explosion of the corporate market during the last three to five years, and the sovereigns continue to issue, I think strategically, more longer-term data, such as when Mexico did a 100-year issue in late 2010. And you harken back to '95, which was just 15 years before, they were having a difficult time accessing the markets at all.
So it has come a long way very fast, but there is not a lack of ideas for places to invest.
Hughes: Great. Thank you, John.
Carlson: Thank you, Bridget.