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Tailwinds for Emerging Markets Corporate Debt

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. As the emerging-markets fixed income space gains popularity, we're checking in with Luz Padilla. She is a manager at the DoubleLine Emerging Markets Fixed Income Fund to get her take on the marketplace today--where she is seeing opportunities and also areas that she is avoiding.

Thanks for joining me, Luz.

Padilla: Thank you for having me.

Stipp: The first question I wanted to ask you about is I think inflation globally is a concern. I think there is a lot of concern about inflation in the emerging markets. As you think about inflation in managing your portfolio, how big of a concern is that to you, or is that a concern to you? How do you manage your fixed-income exposures given that the inflation trend is out there?

Padilla: Yes, we do worry about inflation and the fact that it is on an upward trend, and it's for that reason that we are currently avoiding the local currency space, which is where we think you're going to see a higher transmission in terms of the potential for negative outcomes, especially in rates. And so as a result, we're avoiding local currency bonds and really focusing more on the dollar-denominated sector of emerging market debt, especially in the corporate sector where we see both an upward trend in terms of credit fundamentals and potential rating upgrades, as well as attractive valuations.

Stipp: Would there be at any point when you would begin to consider currency as playing a role in the portfolio? Is there a dynamic that you're looking for where currency would come to play a bigger part in your holdings?

Padilla: Yes, absolutely. I think once we feel more comfortable in terms of the whole interest rate side, and we think that interest rates are expected to continue go up, so that is one side of the equation, which could potentially lead to capital losses in the underlying investments. That's one area that we're monitoring.

The other is really on the currency side or the FX side. There we're very concerned regarding policymakers in emerging-market countries introducing policies to basically cap the strength of their currency, which is the other reason or rationale why one would invest in the local currency space.

We think once that is played out or once that rhetoric dies down and we don't see as many administrative measures or capital controls being imposed within the broader emerging market universe, then we may look at local currency securities for the portfolio.

Stipp: When we last checked in with you, you mentioned that emerging market corporate debt was an area where you're seeing some opportunities, and where you were making some purchases. You mentioned to me the fundamentals play a role in that, but the fundamentals aren't the only reason why you folks are looking in that area right now. Can you explain what else is behind some of your decisions to invest there?

Padilla: Absolutely. When we look at emerging-market corporates, to us they have both the correct mix of positive credit fundamentals as well as attractive valuations. In addition, we feel that emerging-market corporates are also benefiting from crossover investors, and by that we mean investors that are traditionally U.S. investment-grade or U.S. high-yield managers.

We've done an analysis in regards to the portion of traditional U.S. investment-grade and U.S. high-yield indices, the portion that is emerging-market related, and when one looks at the historical trends, we've seen an increase in emerging-market debt, corporate debt specifically, participation in these indices rising from 2% to the current 10% level, and we expect that that will continue to increase as we see more emerging market corporate issuers come to the market.

We also just anecdotally are hearing from traditional, again U.S. investment-grade as well as U.S. high-yield managers that they are looking at emerging-market corporates as basically a place where value exists within their broader mandate.

We recently heard of a manager that was increasing his allocation to emerging-market corporates, and this was a U.S. high-yield manager, up to 30% of his portfolio exposure, which is significant, especially given the magnitude that we're talking about, because when you think about U.S. investment grade, the market cap for that market is about $4 trillion, when you think about U.S. high yield, it's about $1.5 trillion or $1.2 trillion, and then when you think about emerging-market corporates, generally speaking we're talking about $700 billion to $800 billion, and so any additional allocation into the emerging-market corporate space is going to lead to additional demand, and we think will ultimately lead to spread compression in our markets.

Stipp: So it sounds like there certainly are some rising tides here that will help this area in the market. How important, though, is issue selection and being picky about where you place your bets in this area or does it feel like the whole area could be due for some better times ahead?

Padilla: No, I think credit selection is always, of course, important, which is why we feel comfortable investing in this space. We've been investing in emerging-market debt both on the sovereign as well as the corporate side since 1994, and we've been following a lot of these credits both through the good times as well as the downtimes, and so we feel very comfortable investing in this space.

Now as we're seeing new managers coming into this area, we do become concerned especially because the amount of allocations that are occurring perhaps are not the wisest just given the fact that a lot of these managers do not have the track record or the experience in dealing with some of these credits, and seeing these credits through the full cycle, market cycle, and so we think that that could potentially lead to problems in the future, but for right now that certainly has been helpful to valuations as a whole. Our investment style is very much of a long-term buy-and-hold type style. We are looking at credits to own for the long term, and so it is again credit selection is extremely important.

Stipp: Last question for you. I like to get a sense of any areas that you identify as trouble spots, areas that you are avoiding--maybe the portfolio doesn't have any exposure or less exposure or under-representation based on what you might expect?

Padilla: Sure, there are a couple of areas. Number one, obviously, we are concerned with what's happening in regards to the Middle East and North Africa, and so that particular exposure has been pared back. We're also looking at the Chinese property sector, which has grown tremendously, especially over the last couple of years. We've decided to basically avoid that sector, and then selectively there are certain pockets within Latin America that we continue to avoid, such as Ecuador and Venezuela, and those are primarily because of the current leadership of those two countries.

Stipp: Luz Padilla, of DoubleLine, thanks so much for joining me today and for your insights on the emerging-markets bond area. Thanks for calling in.

Padilla: Thank you so much.

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