Download Market Comment - Emerging Market Corporate Bonds

Market Comment - Emerging Market
Corporate Bonds
December 2013
Value Bonds – A winning strategy for
Emerging Credit Markets
Sparinvest’s Value Bonds strategy was launched in
2005. It was first applied to Emerging Markets in
2010 with the launch of Sparinvest-Emerging Markets Corporate Value Bonds. On its 3-year anniversary, this fund instantly achieved 5 Morningstar stars
and was ranked number 1 in its Morningstar peer
group.
Two fund managers, Toke Hjortshøj and Sune Jensen share responsibility for the fund. We asked Toke
Hortshøj about the challenges of introducing the
Value Bonds strategy to Emerging Markets.
In the summer of 2013 talk of the US cutting back on its
money printing programme caused headline-grabbing
volatility in EM bond markets. We used this as an opportunity
to reposition our investments into Investment Grade bonds at
lower prices.
Another effect that we saw during the spring was that local
currencies devalued sharply whilst commodity prices
stabilised. This created some interesting opportunities for us
amongst commodity exporters which we will discuss below.
Investment Grade – sometimes the better option
Dear investor
World economics in 2013
Two factors have dominated global economics in 2013
China’s growth rate – this has slowed from very high to a
lower, but still healthy, 7-8%.
The US recovery – currently being driven by a money-printing
programme that has supported corporate bond markets
worldwide.
As investors in Emerging Market corporate bonds, we prefer
to see a slower growth environment. During such times,
company managers are more prudent with their money and
more focused on setting cash aside to repay their bonds.
Having the flexibility to invest in bonds from across the ratings spectrum has been an important factor the success of
our strategy. Whenever we feel that we aren’t being paid
enough to take on the risk of buying High Yield, we look at
the relative value of Investment Grade. This summer all
Emerging Markets bonds were hit on Fed. tapering talks, but
the relative spreads on Investment Grade looked more interesting, as did prices. We used the opportunity to buy into
December 2013
Emerging Markets Update
them. This had the effect of lowering the overall risk of the
portfolio without reducing its potential yield.
of view, for companies that had issued debt in hard currencies, this would have resulted in a short-term rise in leverage.
However, we felt comfortable about our investments for the
following reasons:
Working with political risk
Looking back over the past three years of managing the
Value Bonds strategy in Emerging Markets, what is really
striking is how unpredictable political agendas can be. Even
minor changes to legislation can have unexpected impact on
business. We have had to be very focused on diversifying
risk both within regions and across countries. Given that ours
is essentially a bottom-up process, this element of adjusting
the portfolio to maximize geographical diversification is rather
new. Here we have found the World Governance Indicators
(WGI) helpful in assessing the reliability of property rights and
rule of law, among other things, in different nations. If we are
getting a pledge of assets or property to back the bond investment, we need to know that this is something we can
put value on. WGI rankings help in the final stages of comparing similar bonds from different countries.
Working with political agendas
Within the Emerging Market universe there are a number of
countries where politicians decide everything (notably China
and Russia). In such circumstances it becomes very important
to align portfolios with policymaking. For example in China,
we try to link our investments with the Government’s 5 year
economic plan. The Chinese Government is quite clear about
its goals. It wants: - a domestic demand-driven economy,
urbanization without isolating rural areas and all of this with
a focus on environmental issues. Following this thinking, we
invest in companies tackling environmental and infrastructure
issues. For example our portfolio includes waste water management, and manufacturers of water pipes and control
systems for high speed trains and tubes. Meanwhile, from a
creditor point of view, we find that Chinese and EM financials
are in the wrong place in the debt/equity cycle for us to find
them interesting. They are increasing their credit risk which –
for a debt holder is not the route to good performance. We
maintain 0% exposure to financials.
Currencies and commodities
Our portfolio currently contains a relatively high proportion of
commodity exporters. One effect of the spring/summer uncertainty was that many EM currencies were devalued
against the ‘safe haven’ dollar. From a capital structure point

We select companies which have low leverage compared to the market average

Commodity prices have stabilised and, as exporters, our
companies have the long-term advantage of being
paid in dollars whereas their cost basis is in local currency
The combination of the above factors, plus a strong focus on
cost reduction, has pushed up margins and profitability for
commodity companies, leaving them in a better position
today to handle lower demand.
From the outset, our fund has invested in hard currency
bonds only. To mitigate the local law risk we have preferred
bonds issued with UK or US law documentation to increase
transparency and security. This means international accounting standards apply and there are regular announcements (in
English) to bondholders.
Demographic opportunities
Population growth is an economic strength for Emerging
Markets with many also seeing a rapid growth of their middle class. As people become richer, they consume more and
aspire to home-ownership. When we invest in the bonds of
a company, we need to care what kind of business it is
because if demand for whatever it is producing were to
disappear, then we are in trouble. That’s why we try to align
our portfolio to sectors where demand is unlikely to disappear - like food or energy or commodities used in construction. With a growing world population (and importantly a
growing middle class in Africa), it makes sense to think
about the impact of demographics and to invest in goods
that are in constant demand – meaning low probability of
excessive supply.
Taking advantage of US recovery.
We believe that the US is now in an established recovery
phase and this is one of the reasons why we have a significant exposure to Mexico - in industrials, materials as well as
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December 2013
Emerging Markets Update
retail companies. On a historical basis, there’s a high correlation between growth in the US economy and spill-over
growth – with a lag – in Mexico’s. Growing the US economy
will have a positive impact on Mexico’s middle class.
Please see page 4 for an indication of some of the diverse
value opportunities that we find in Emerging Markets. I look
forward to writing to you again in March.
Recent EM Value Bonds purchases
A high premium for off-benchmark bonds
What has kept the spread level down in Emerging Markets
recently is the massive liquidity resulting from QE. That’s why
it interests us to look at non-benchmark bonds.
Say a company wants to raise a $150 million bond, it will
not be a part of the benchmark because it’s a small issue.
Bigger investment houses are less willing to use research
resources on smaller, non-benchmark companies or smaller
issues. But what’s important to us in the Value Bonds team
is the company behind the issue. If the fundamentals are
strong and expected return = versus risk = balanced, we will
invest! This explains how we can get yields of 10-13% in a
very strong company with a pledge on assets whilst the
benchmark is only paying between 6-8%. So investors need
to be aware that there’s a high premium for being outside
the benchmark.
Investing in EM with a Value Bonds strategy gives us a tilt
towards smaller company bonds because they pay higher
returns. On top, we prefer bonds issued with pledge on
assets. Smaller company research is more complex - which
increases the importance of having an experienced portfolio
management team.
Outlook
Lower economic growth removes bottlenecks in countries
like China and Brazil where growing salaries were lowering
competitiveness. Now company management is focused on
keeping salaries at reasonable levels and strengthening
balance sheets. So in terms of the likelihood that bonds will
be repaid, this is the best place to be in the credit cycle. This
makes us confident for the prospect of good returns in the
year ahead
We are very pleased with the success to date of our Value
Bonds strategy in Emerging Markets and believe that we will
continue to find opportunities to boost returns by investing in
attractively-priced smaller company bonds while keeping the
risk profile of our portfolio attractive by buying into Investment Grade bonds when they offer higher risk-adjusted
potential.
Gold Mines in South Africa
Gold is highly valued in many Emerging Market nations and,
with a limited global supply, the long-term prospects for gold
miners are good, especially among low-cost producers. During and after the summer break we increased our exposure
to two South African gold mines. They had both been punished because of weakening currency, weakening commodity prices and because they were based in South Africa. But
when we looked deeper into their worldwide revenue base,
we found that these two companies got less than 35% of
their revenue from South Africa. The non-South African revenue base is more than sufficient to repay our coupons and
bonds.
Beef in Brazil
Despite the enormous agricultural potential of the African
continent, production standards and knowledge remain low,
so efficiency needs to grow a lot before they can contemplate stopping imports.
Brazil, on the other hand, is known as ‘the food basket of the
world’ Here we have increased exposure to a beef producer
in the belief that world demand for beef is unlikely to slow.
It’s a company that has turned from being growth-oriented to
being focused on cost-cutting and selling off non-core assets
to build its cash levels. So today the company has cash to
cover all its debt until end 2016! And it continues to sell off
assets.
EM Energy Exposure
Worldwide demand for energy is also on an upwards path.
In the Emerging Markets we gain exposure to this sector
through the bonds of EM-based manufacturers of the
equipment needed by global exploration companies. New
equipment can be moved around the world and is less likely
to cause environmental issues than old. As focus on environmental risk factors grow, it becomes more important for
exploration companies to replace old equipment, which
keeps demand high.
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Emerging Markets Update
Yours faithfully
Toke Hjortshøj
Senior Portfolio Manager
On behalf of Sparinvest’s Value Bonds Team
December 2013
The mentioned sub-fund is part of Sparinvest SICAV, a Luxembourg-based,
open-ended investment company. For further information we refer to the
prospectus, the key investor information document and the current annual /
semi-annual report of Sparinvest SICAV which can be obtained free of
charge at the offices of Sparinvest or of appointed distributors together with
the initial statutes of the funds and any subsequent changes to such statutes. Investments are only made on the basis of these documents. Past
performance is no guarantee for future returns. Investors may not get back
the full amount invested. Investments may be subject to foreign exchange
risks. The investor bears a higher risk for investments into emerging markets.
The indicated performance is calculated Net Asset Value to Net Asset Value
in the fund’s base currency, without consideration of subscription fees. For
investors in Switzerland the funds’ representative and paying agent is RBC
Investor Services Bank S.A., Zurich Branch, Badenerstrasse 567, P.O. Box 101,
CH-8066 Zurich. Published by Sparinvest, 28, Boulevard Royal, L-2449
Luxembourg.
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