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Gomez: Emerging Markets Bonds Can Continue to Outperform

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. It's International Investing Week on, and today we're focused on the emerging markets.

I've got on the phone with me today, Michael Gomez from PIMCO Emerging Local Bond, and he is going to tell us a little bit about he is seeing in the emerging-markets bond space.

Michael, thanks so much for calling in today.

Michael Gomez: Thank you so much for having me.

Stipp: First question for you, the category returns in the emerging markets bond category have been very good over a several trailing time periods. My question for you is, do you feel like this area of the market may be a bit overheated, maybe the market has gotten a little bit ahead of the fundamentals in the emerging markets bond space? What's your take on valuations today?

Gomez: Well, we still think that there is good value remaining in emerging markets fixed income. You're right that the total returns have been very strong. And in 2010 year-to-date, they are also very strong. But I think that we need to take a more granular look at different portions of the asset class and deconstruct where those returns are coming from.

So, if you look at the external debt portion of the asset class, what you see is that this is a very long duration asset class, over seven years of duration. And so the total returns have in large part been driven by the very strong rally that you've seen in U.S. Treasury yields and the associated tailwind that that's given to emerging-market external debt.

Spreads are only about 15 basis points tighter on the year. When you look at local markets, what we've seen is both the compression in local markets yield as fundamentals have started to exert themselves and also, more recently, you've seen a tailwind in terms of total returns coming from the currency side.

So, you're right to say that the returns have been strong, but our sense is that this is an asset class that can continue to outperform relative to the global fixed-income opportunity set.

Stipp: As you're looking out across your investment universe and your stomping grounds, are you finding any areas where the opportunity looks particularly compelling? And on the flipside, are there any areas where it looks like it may be time to trim or to be a little bit more cautious?

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Gomez: We continue to think that the local markets portion offers great value. When we look across emerging markets, and we compare emerging local opportunities against sovereign external opportunities, what we see is that moving away from external and into local essentially allows an investor to go up three notches in credit rating. They can go down about two years in duration, and at the same time they went to picking up roughly 75 basis points in carry. So, when we see those three characteristics: higher in credit rating, down in duration, and up in carry, those are indicative of a relatively attractive opportunity set. So, we've been moving more of our assets into the local space, and we continue to think that that's very attractive.

Stipp: On the question of fundamentals, I think a lot has been written recently about how a lot of the emerging and developing world has pretty strong fundamentals compared to some of the fundamentals that we've seen in the developed world, with some of the debt problems that several countries have. How would you characterize the fundamental situation in the emerging markets versus the developed world today?

Gomez: Well, I think you're right that, for the most part, we see that emerging-market fundamentals are relatively strong. So, when you look at just basic stock debt numbers, emerging-market debt to GDP as an overall asset class figure is about 35%. In the developed world it's about 100%.

When we look at flow data, we also see that emerging-market balance of payments, particularly in the current account, tend to be characterized by surplus, as in the developed world, they are deficits. So not only from a stock basis, but from a flow basis, emerging markets also look very comfortable.

So, the fundamentals look good. So, in addition to the debt side and the balance of payment side, also the growth outlook for emerging markets looks much more robust and self sustainable.

I think the other part of the equation that we always have to consider, though, is what is the pricing of those fundamentals and pricing of the risk. And there I think we've reached a point where after a multiyear voyage of emerging-market sovereign credits being underpriced and undervalued, I think today we would characterize them for the most part as being relatively fair value. So, much of the improvement in a story like Brazil, which is a BBB minus rated credit, is now I think pretty much reflective in five-year credit risk levels that trade around LIBOR plus 110 basis points. A similar comparison can be made to a country like Indonesia, which is a solid BB and perhaps very much on a its way to being an investment grade credit itself, but again five-year credit risks there trades around LIBOR plus 150.

So, when we look at these types of spreads, we say, this is an asset class whose economic volatility and also financial markets volatility we think is on a continued declining trend, but where valuations I think for the most part reflect that fair value after many years of being mispriced and undervalued.

Stipp: You mentioned at the end of your answer they're about volatility. I wanted to ask you a question about the risk factors that investors should have in mind if they're considering this asset class. I think a lot of investors have been seeking more yield, especially fixed-income investors, given the low yield environment that we have today. What should be on their minds as far as risk controls in this area?

Gomez: Well, I think the temptation is to have very generalized discussions about emerging markets. And for the most part, we've had a very generalized discussion so far today. But what we really need to stop and recognize, and always keep in mind is, this is a very heterogeneous asset class; 35 to 40 countries, which are much different trajectories in terms of economic growth, whose policy constraints are widely varied, and whose social structure and geopolitical realities are also very different.

So that coupled with a reality that the outlook for the developed world in the backdrop for global growth is still quite challenging, means that we think that now more than ever, investors really need to take a prudent, differentiated approach to investing in the emerging markets. And we still believe that moving up in credit quality or having a higher credit quality bias is the right way to go.

When we look at signals in the Fed, of course, and those recent signals has come from QE2, we have to keep in mind that this sends a very cautious and in many ways sends up a warning signal about the state of the U.S. economy a full two years after Lehman Brothers. So, we have to make sure that we are understanding the signals that policymakers are sending us about the state of the developed world and the risks and opportunities about investing within that.

Stipp: Speaking of the QE2, the last question I wanted to ask you is with regard to currency, and I think that the Fed's recent policy decision has stoked some concerns about devaluation of the dollar over the medium or the longer terms. What's your take on the currency situation today and the currency exposure that investors may get by investing in emerging markets bonds?

Gomez: Well, I think the nice thing about this asset class is that we can pick and choose the areas that we want to express a sophisticated view. And when it comes to the currency side, in our mind, there is a wide set of evidence that suggests that the dollar needs to continue to correct, in addition to the most recent policy measures that you mentioned, namely, QE2.

But the question is, if we're going to get a depreciation of the dollar, what is it going to depreciate against? What are the right and appropriate groups of currencies to express that view. And in our mind, we still think that there is plenty of opportunities to express that view against Asian currencies. Here, the long-term fundamentals are very supportive of a continued depreciation of Asian currencies.

When we look at valuations, we still think that many of the currencies in this region are some 20% to 30% undervalued against a dollar. And when we look at the global economic landscape, and we see the continued call for rebalancing of the global economy, which is still to this day fairly characterized by large imbalances between the West and between Asia, we think that the currency appreciation from Asian bloc will be part of the toolkit that serves to rebalance this global economic construct.

And so from all those perspectives, from the fundamental perspective, from a valuation perspective, and from a policy perspective, we think Asian currencies are a good way to express this trend, this idea of a weakening dollar.

Stipp: Michael Gomez of PIMCO Emerging Local Bond, thanks so much for calling in today and for your insights.

Gomez: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.