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PIMCO's Lupin: Still Plenty of Value in Emerging-Market Debt

Eric Jacobson

Eric Jacobson, our director of fixed-income research, recently visited PIMCO's offices and sat down with emerging-markets specialist Lupin Rahman to learn more about how PIMCO is positioning in this increasingly popular area of the global market.

Eric Jacobson: Lupin, thank you so much for being with us today. Appreciate it.

Lupin Rahman: Thank you for having me.

Jacobson: So, Lupin, you're an emerging-markets specialist, and we want to ask you if you would, please, give us a little bit of thumbnail about where things stand in terms of the macro picture, how it effects global, and EM in particular, obviously. Then maybe we'll talk a little bit about what that means for portfolio positioning not only in dedicated PIMCO portfolios but some of the others as well?

Rahman: So, EM is in a very positive environment currently. We're very constructive in terms of the investor investments into the asset class and also the general macro environment.

Rebounding from the crisis has been very strong across all regions. We're seeing some inflationary pressures building in Asia and Latin America, but in general, the overall environment has been extremely positive.

This has been aided to a significant effect by the stronger policymaking and the stronger credibility of EM institutions. So, we're also seeing investments coming into both the local markets and the FX side of the EM strategy.

Jacobson: When you say the FX side, can you explain that a little more?

Rahman: So, in terms of investments into local markets, you've had traditionally the local rates aspect of investments, which have attracted a certain class of investors, and also the currency appreciation and valuation aspect of investors.

In this recent period, we're seeing a strong interest in emerging-market currencies, not only because there is a very strong appreciation story but also because the cyclical trends are pointing to an acceleration of that appreciation story. So, for example, with China de-pegging off the U.S. dollar peg, this allows Asian economies greater scope for allowing their currencies to appreciate. We're also seeing greater valuation trade-off in terms of allowing currencies to appreciate versus using interest rates to combat inflationary pressures.

Another interesting aspect of the recent environment is the U.S. dollar bid. Given the crisis that we saw in the Middle East and in the Eurozone, it's interesting to see that the U.S. dollar bid has been a lot weaker than in previous cycles of crisis. So, all of this points to a more structural interest in emerging markets and in emerging market currencies in particular.

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Jacobson: So, along with the fundamentals that you just described, as you well know, there's been a lot of flows and a lot of interest, particularly as U.S. spread sectors, if you will, have become pretty tight relatively speaking. What can you tell us about where you're thinking in terms of the valuation story in the EM markets and whether or not we're in that neighborhood of getting to a fully or fairly heated value situation?

Rahman: I think that the very strong interest that we're seeing in the emerging market asset class is related to two factors. One is the pricing, as you mentioned, that market spreads in U.S. investment-grade credits and advanced-economy credits have become in general tighter.

The other aspect is this secular shift in investor psychology moving away from advanced economies towards emerging markets, and I think that's a point that's extremely important to highlight in terms of what we at PIMCO call the "New Normal." As the investor base recognizes that emerging markets is where the majority of global growth is coming from and is likely to come from in the future, they're allocating much more of their resources towards this investment group.

What does that mean in terms of valuations? For us, we see a lot of value remaining in the external credit space within the emerging-market world. While we've seen a flattening of the sovereign credit curve, there is value to be made in picking up corporate credits in the investment grade sovereign and emerging market space. So, quasi-sovereigns and corporates that are relatively high rated. We also see…

Jacobson: And you're speaking particularly of either hard dollar or other non-local currencies or the other way around?

Rahman: I'm speaking mainly of dollar-based credits. So, in general, while we've seen external currency credits in the sovereign space tighten to relatively tight levels in the BB category, and still wider than the pre-Lehman crisis levels in the investment-grade category, we are still seeing opportunities to pickup carry from exposures in quasi-sovereigns in that space and in corporates in that space.

When we're moving to local assets and comparing external valuations versus local valuations, our view is that there remains ample opportunity in the local space and particularly in the currency space in terms of relative value across EM asset classes.

Jacobson: So, if you could sort of wrap that up into a tighter picture, then, in terms of what it implies for PIMCO's positioning across those areas, whether it's the corporate sovereigns, U.S. dollar versus local, maybe give us some feel for that?

Rahman: So, at PIMCO, we have a strong interest in EM in general, and a significant component of that interest is in the local markets in terms of both having exposure to emerging-market local rates products and emerging-market currencies.

Jacobson: When you say across PIMCO, just to clarify, you include in that point, portfolios like perhaps PIMCO Total Return and others that are not by any stretch EM-dedicated portfolio. They're essentially multi sector?

Rahman: Absolutely. So, I'm speaking of both dedicated and non-dedicated assets being allocated towards emerging market local mandates as well as emerging market external mandates.

Now, in terms of trying to scale opportunities, we are trying to invest our dedicated and non-dedicated assets in those parts of the currency space in EM where we see the greatest appreciation potential as well as the greatest total carry, adjusted for risk.

In the local rates area, we're looking for countries and credits where we have real returns and a much lower hiking cycle expected than what's priced in. Given the inflationary backed in EM, this is challenging, but there are still pockets of relative value within that space.

In terms of the external credit exposure, here we are looking to add value in the corporate credit space and in the sovereign credit space where we feel that the ratings migration potential is higher.

So, in each of the three asset classes, there is a component of selectivity in where we would have our exposures, but in general, a significant component of our exposure would be in the local markets.

Jacobson: And just overall in terms of your dedicated portfolios, if I'm not mistaken, it's more than half in dollar-based external debt, is that correct, in terms of your portfolio positioning right now?

Rahman: That's correct.

Jacobson: Can you give us a rough idea what the breakdown is across the three?

Rahman: So, in our dedicated portfolios we tend to have a breakdown of more than 50% in external credits, so U.S. dollar-denominated sovereign and corporate credits, and a breakdown of about roughly half between the local rates and the FX components.

Jacobson: Well, thank you so much. We appreciate your time.

Rahman: Thank you.