Michael Conelius, manager of the T. Rowe Price Emerging Markets Bond Fund, says some of the world’s biggest troublemakers have changed their ways.
Q. Iraqi bonds accounted for nearly 5% of your portfolio at the end of June. How did you end up with this position?
A. I've done this for 20 years, and some of the best value-added that I've been able to generate has come from distressed countries and contrarian positions. So, I have a predisposition to look at things that other people are shying away from. We bought the securities while Iraq was still in default before the [2003] restructuring, paying about 15 cents on the dollar. This year it's been one of the best performers; last year, it was a great performer up until the fourth quarter and then it fell apart with the capital markets shutting down: all illiquid assets suffered, including Iraq.
The important thing with Iraq is the longer-term view of the fundamental strengths of the country relative to its very modest debt burden. Eighty percent of the debt was written off, while there's ample debt-servicing capacity from existing oil production, not to mention the huge potential in new production [from] new investment into the country. It has many, many other problems, obviously. But the long-term strength that we see in the country's fundamentals out five to ten years gives us a lot of conviction to have that very large relative position.
Q. How do you discount the political risk in a part of the world were bad things have happened and continue to happen?
A. You're still paid for that from a relative value standpoint. The bonds trade now at maybe a 10% yield, when the rest of emerging markets pay 6% or 7%. So, there's a fair amount of extra cushion in a market that has very little default risk in my mind. And we're willing to live with the extra volatility.
Q. Is there much of a liquidity risk?
A. At the end of last year, illiquid assets were just cast aside: Iraq, Serbia, Ghana, Gabon, Indonesia—they traded down hugely in the fourth quarter, post-Lehman. Nothing to do with any of those countries; it was more the breakdown of the financial system. You're questioning whether Citibank will survive, and you're asking Citibank to rapidly deleverage and shrink their balance sheet; the last thing their trading desk is going to do is to buy illiquid bonds. So, there was no bid.
Q. That must have been an awful time, because it looks as if Iraq, Serbia, Ghana, Gabon, Indonesia are among your top ten holdings.
A. Yup, and they're probably in the top ten in year-to-date performance.
Q. Your assets have grown fast over the last decade.
A. It's a secular trend of recognizing emerging debt as a viable, maturing, stabilizing asset class, and now one that is in some ways in a better relative position than the developed markets. [Their] financial systems were not so developed that they had crazy leverage, fiscal policies have generally been positive rather than deteriorating, as they are in the G7. And you still have the benefit of commodity exposure. Emerging markets tended to build up and hoard hard-currency reserves. That put them in a very good position to weather the crisis and come out of it in some ways stronger.
Q. Serbia is one of your bigger bets. What’s the investment rationale there?
A. I’ve touched on the theme of debt restructuring being a great source of [excess returns] over the years. Another theme we [look for] is convergence—where a country is converging with the EU, or in Mexico’s case NAFTA. The government can sell tough policies if the end result is…
Q. …“we will live like them?”
A. Exactly. A decade ago, the Serb was a pariah. So, if the end game is that they can have an EU passport and travel without visas to Paris and London, they’re willing to bite the bullet and take some medicine. So: great human capital, a commitment to joining the EU. We’re still the largest investor in the bonds in the country, and it’s done extremely well for us.
Q. Could you talk about your positions in North Korea and Lebanon?
A. North Korea is a very small position and it is effectively a call option on reunification. It will happen one day. And this debt will be restructured; most of it will be written off. But the residual claim will be on a unified Korea. So, there’s some upside there. With Lebanon, one of the positives that came out of the analysis of Serbia was the power of remittances. Serbs that live abroad send back 20% of the GDP. The Lebanese do it in similar magnitude, and Lebanon has one of the best banking systems in the emerging world. So, there’s a lot of debt in Lebanon, but there’s also a captive audience that’s happy to buy this debt.
Q. Is there something to the idea that there are not many bargains out there right now?
A. Yes, there is. We still feel like the markets have not fairly priced some of these second-tier countries, so we remain overweight Serbia and Iraq and Kazakhstan. Corporates are interesting, if not nearly as interesting as they were in the first quarter, when default was being priced in. So, now our incremental money is really going to corporations largely, and recovery plays, like companies that give me exposure to domestic demand recovery in Brazil, or in Russia.
Q. Is the market overall expensive?
A. We’ve fully reversed the Lehman-triggered cheapness. Emerging bonds are approaching expensive levels. In the near term, we’re probably a little stretched and could do with a pullback. But the fundamentals are so strong that any dip would likely be bought.
Q. Thank you.
—Igor Greenwald
