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Emerging Markets Mature

Ryan Leggio

Ryan Leggio: Hi. I am Ryan Leggio. I am a mutual fund analyst at Morningstar. We're here in Los Angeles at DoubleLine, and with me today is Luz Padilla, the manager of the DoubleLine Emerging Markets Fixed Income Fund.

Luz, thanks so much for joining us today.

Luz Padilla: Thank you for coming in.

Leggio: The first question I wanted to ask was really how investors should look at an emerging markets' fund in the context of a total portfolio? Is this something that provides a good diversification benefit at all times for investors?

Padilla: I think if you look at the history of the asset class, the asset class really has matured from being really a high-yield only type of asset class to now where, 15, 16 years later, into an asset class that really deserves a place in a well balanced fixed income portfolio.

Just starting with the history of returns: If you look at the returns, the returns have been in the low double-digits, somewhere between 10% and 12%, again, per annum for that full history. And in addition to that, you've had a very nice transition or upward migration of the asset class, again, from just a plain high-yield to almost now being on the cusp of becoming an investment-grade asset class.

Leggio: So, you are the manager right now of the DoubleLine Emerging Markets Fund. Previously, you were for years, the manager of the TCW Fund of a similar name, and where are you finding the opportunities right now? Credit spreads in the United States have really narrowed. Where are the opportunities in emerging market countries?

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Padilla: Right now, we're really looking at the emerging market corporate space. Again, when you look at emerging market debt, you have the sovereign hard currency debt, you have the corporate hard currency debt, and the local currency. I think in terms of the sovereign, certainly credit fundamentals have migrated up and spreads deserve to have narrowed in that timeframe. But now we're at a point where we think that the valuations are just not there relative to comparably rated securities.

In the corporate space, we don't feel that that's the case, and we think that there is still additional room for spread compression, as well as upward credit migration, as we see the sovereigns again continue to improve their overall credit ratings.

Leggio: And I know we talked about some of the opportunities in Brazil and in Mexico. Can you give us an example where the corporate credit on a risk-adjusted basis, similar maturity, looks a lot more enticing than a sovereign credit of the same country?

Padilla: Sure. In Mexico, for example, we have a position in one of the large Mexican banks. This is a bank, again, that is one of the top-tier banks in Mexico, has bonds outstanding that are probably going to be called within a year and half. The yields for that type of security are upwards of 6% versus the Mexican sovereign, which for a 10-year maturity, yields about, I'd say, 4.5% to 4.75%. And so the difference there I think is significant enough in terms of the valuation proposition while minimizing the risk tolerance. And so, for us, we're looking for securities that have the potential for higher returns, but also not necessarily going up in terms of the risk profile.

Leggio: So, emerging market debt funds have seen a lot of investor interest, especially because of the diversification benefits in regards to currency, and I know you have some specific views about that. What do you think right now of those benefits or the lack thereof?

Padilla: Well, at this point, we're really avoiding the currencies for our fund. And in particular, there are two things that concern me; number one, really, just the global backdrop. It's one of the reasons why the fund is primarily positioned in investment-grade-rated securities within the emerging-market debt universe. And so, while we're still trying to figure out how the European situation is going to play out and whether we are going to head into a double-dip type of economic outlook here in the U.S., we'd rather position the portfolio and securities that we think are going to be able to better withstand that kind of environment. And local currencies just seem to have more volatility than these other types of securities.

And then the second reason for not being in local currencies at this point is that, what we've noticed, and it's really a negative trend is, once the currencies start to strengthen and get to a certain point, we start to see some of the governments introduce policies to basically weaken those currencies, which really limits your upside. And so if you are really going to be there and take on that additional risk and potential for volatility, then you should really have the benefit of that additional upside. But what we've seen is that, that upside sometimes gets capped, and we really don't have a way of determining when that's going to happen and that's what keeps us out of currencies.

Leggio: So, you are certainly seeing opportunities in your fund, but if we take a step back, you helped with Jeffrey Gundlach, the manager of the DoubleLine Core Fund, look with the other portfolio managers and sector specialists where the values are around the globe. Can you tell us generally if your particular sleeve in that fund is overweight or underweight, and then how does that compare to a year or maybe even two years ago?

Padilla: Well, our particular sleeve probably has an underweighted allocation, and I think it, again, it's because of the value proposition. When we look at other sectors, and we are certainly very positive in terms of the underlying credit fundamentals and the potential for that to continue to improve, when you look at the types of yields that you are achieving in this type of space, they don't compare as favorably to some of the other sectors within the Core fixed fund.

And so at this point, we do have an underweight, I think that has been the case for a while, and it's primarily because, again, there is a particular sub-sector of the mortgage market that seems to offer a tremendous amount of value. So, when we look at how to allocate our credit risk that happens to have an overweight at this point in time.

Leggio: Besides the currency thinking for a lot of investors with emerging-market debt, the other thinking is diversification and maybe help against rising rates, similar to what a high-yield fund in the United States might provide.

Any thoughts on how an emerging-markets fund can also help an investor's portfolio in similar ways that a high-yield fund might, and are there better opportunities in an emerging-markets fund than a high-yield fund right now?

Padilla: Well, when we look at the high-yield portion of our fund, because one of the nice things about investing in emerging debt is that you can really invest across the whole credit spectrum, and while we currently have the bulk of our positions in investment-grade-rated securities, we do have an allocation to high-yield securities. And when we look at the high-yield portion of our fund, we compare those spreads and valuations relative to comparably rated developed-market high-yield securities.

And at this point, we are finding that there is still value in the emerging-market corporate high-yield, somewhere between a 100 to 150 basis points, plus you also have the potential for additional upside. A lot of these companies have strong partners that could potentially lead them up in terms of the credit migration path, and so that's why we like certain of those opportunities in the emerging high-yield sector at this point.

Leggio: Great. And the last question I really wanted to ask was, there is really big concerns and DoubleLine certainly shares this view, deflationary pressures out there, the global economy slowing not just because of Europe, but stimulus all over the world is kind of wearing off. How is that affecting countries like China, and then the peripheral countries that really get a lot of their growth from Chinese demand, are you seeing any big trends that investors should look out for?

Padilla: You know, at this point, I think everybody is still waiting for the next step in the chapter of the U.S., China and/or Europe.

What we've tried to do in our fund really is just to position the fund so that one, we can have returns, I would say, on a best-case outcome, somewhere in the high single digits, and in the base-case/middle-case outcome, somewhere between 7% and 8%.

But if we really go down that negative path that we're going to be able to hold basically most of our gains. And so what we are trying to do really is position the portfolio defensively, which is why we are invested in the investment-grade sector.

We are positioned on the shorter end of the maturity spectrum, and it's simply because what we've noticed is that when the risk-off trade is on, the benefits that you get from the lower Treasuries are basically outweighed by the spread widening that you see in most of the credits in the emerging-market debt universe. And so what we are trying to do, again, is really to make sure that we limit the downside and still take advantage of the upside.

Leggio: Well, Luz, thank you so much for joining us today.

Padilla: Thank you.

Leggio: And thank you for joining us. This is Ryan Leggio for Morningstar.