Jan Dehn is the type that doesn't back down from a Twitter war with FT reporters. Don't trash on his beloved emerging markets (EM), or you're going to get an earful in 150 characters. It's almost personal. China hard landing? Hogwash. Yes, the debt levels are higher than ever. We know. But China's bond market is opening and is investment grade. Chinese companies — and the government — are going to find buyers.
Belarussian B rated debt: who wants it? "I love it. We have been actively invested in Belarussian bonds for many years...and continue to have exposure. We have been overweight Belarus all year," he says.
Argentinian pesos? Ashmore fund managers were overweight back in 2009, six years before Mauricio Macri ended the Peronista reign of the Kirchners, a presidential couple that defaulted on foreign debt twice. "Our biggest Argentina trades were to go zero weighted before the default in 2001 and go long in April 2009 when the market was trading Argentina bonds at 2000 basis points over Treasury...priced for another default," he says. The country hasn't defaulted since.
If you time it right and have the patience, you will be greatly rewarded. Those are words to live by for Dehn and his like-minded money managers at the Ashmore Group, a $65 billion emerging market specialist in London. They celebrated their 25th anniversary in November.
Dehn spent most of his adult life outside of his home in Denmark, in places like Tanzania. Now he's on Aldwych Street across from the London School of Economics at Ashmore. He's their head of research. He came to London via New York in May 2005, where he served as a fixed income analyst for Credit Suisse First Boston. All day long, he is trying to find the best sources of yield and capital gains in emerging market debt.
Since 1992, a $10,000 investment in the Ashmore EM Liquid Investment Portfolio (EMLIP) is now worth around $280,000. They're neck and neck with Berskhire Hathaway. The fund has outperformed the JP Morgan Emerging Market Global Diversified Bond Index and the S&P 500 with lower volatility since inception. For Dehn, that's evidence of massive inefficiencies in the market. "If an asset class has higher return and lower volatility it is a superior asset class," he says. And so the takeaway..."Investors need to have more money in emerging markets than they have in U.S. stocks."
Ashmore runs 10 mutual funds open to American investors. The initial investment is $1 million for institutional and $1,000 for retail mutual funds.
On a cloudy November afternoon, Dehn has his sleeves rolled up in an office meeting space at Ashmore, flipping through printed slides, showcasing bond spreads. He correctly called the Russian bond bull in Dec. 2014 when spreads were 700 points over Treasurys. As a contrarian, that's the time to pull the trigger -- when spreads are at their worst, signaling doom, and yet you believe there is enough evidence that the market is wrong. Within a year, Russian bond prices contracted 400 basis points, meaning Russian bond prices rose. Investors who bought beforehand were getting high yield and impressive capital gains once bond spreads compressed.
There truly are once in a lifetimes, and that was one of them for Russia.
Ashmore thrives on distress. When Enron went belly up, Ashmore bought their physical assets like pipelines throughout emerging markets for a fire sale and sold most of them for a profit. They like Venezuela's PDVSA bonds, the super-duper junk bond of global oil companies. PDVSA was in a restricted default in November, paying its bondholders late. Sinopec -- a Chinese energy company that has lent money to PDVSA -- is suing them. Ashmore, meanwhile, has it as a top five position in one of their mutual funds.
Yikes.
"Most bondholders believe they'll be paid," Dehn says. This was the source of one of his most recent Twitter spats with the FTs emerging markets editor Robin Wigglesworth. "Venezuela credit has traded 3000 basis points over Treasuries since 2004 and it never defaulted. Investors are being paid 25% to 30% per year in yield, plus there's plenty of opportunity to generate alpha because of volatility," he says, selling himself on the Venezuela bull case, if a case can dare be made. Venezuela's chief debt negotiator is vice president Tareck El Aissami. El Aissami is sanctioned by Treasury. They call him a narco-trafficker.
"PDVSA bonds trade in the 20s and their recovery value is double that. A default would be messy...and there would be considerable uncertainty, but at current prices, you ultimately double your money," he says. "They are paying...but money is coming in late."
Venezuela is the very definition of 'wild and crazy' as far as Ashmore investments. Their fund managers hold Pakistani debt and the bonds of other frontier markets. But nothing is as nuts as Venezuela. At this point, bitcoin is safer.
Within the low grade credits of Latin America, Ecuador is a stand-out. "The government is very market friendly," he says. "Transparency is improving so you know what you're buying, and you get 9% yield in dollars."
Retail investors who are looking to get into emerging market bonds on the cheap have two BlackRock products, the iShares JP Morgan U.S. Dollar Hard Currency EM Bond (EMB) or the iShares Local Currency EM Bond (LEMB) exchange-traded funds. LEMB is up 11% this year. EMB, 5%. Both beat the two medium-term (IEI) and long-term Treasury bond (IEF) ETFs over the last 12 months.
See: HSBC Says Tailwinds Blowing For Emerging Markets Heading Into 2018 -- Forbes
Are You Ignoring This Serious China Investment Thesis? -- Forbes
The Case For EM Bonds (Turkey No, Brazil Yes)
Global investment firms dipped their feet into emerging market bonds this year, but smaller retail investors still prefer to stay home.
"It is hard to get the international story across because international exposure has hurt them over the years," says Crit Thomas, global market strategist for Touchstone Investments in Cincinnati. "Emerging markets have been a drag for years because all of the money was in the U.S. But with the U.S. more expensive now, I don't think it has helped convince the average advisor to put portfolio money abroad. You can pitch them to the contrary. They are influenced by what happened, not what could happen," he says.
What's happened is if you put any money in emerging markets over the last 10 years and trimmed from the U.S., you lost around 8% while the S&P 500 rose 77%. Emerging market bonds, however, have done better than U.S. Treasury bonds over the same period. Local currency bonds have done poorly due to a stronger dollar.
If consensus is right, here is what could happen: a longer-term recovery is underway in most emerging countries based on value, fundamentals and largely underweight positioning by institutional investors.
"Our long-held investment view on emerging markets has been that the market represents value and one should take advantage of any dips to get exposure, and we retain that positive stance," HSBC strategists led by Murat Ulgen wrote in a 20-page report dated Nov. 16.
Bond fund managers who believe the Fed and European Central Bank will unwind their bond purchasing program, and will do so in an orderly fashion, think countries like Brazil and India and China are enticing.
Quantitative easing (QE) was the largest and most distortionary intervention ever made in financial markets with trillions of dollars being pumped into supporting domestic bond markets. Markets quickly adopted three basic views about the effects of QE: it was bullish for the U.S. based on the expectation of strong growth, inflation and rate normalization; bearish on EU because of weak growth, no inflation and negative yield. Big investors reduced exposure to EM because central banks were not on their side of the fight.
"The institutional investor is coming back," says Dehn. "We estimate that so far only one-fifth of the institutional money that left between 2010 and 2015 is back. Ninety percent of our portfolio is institutional investors and in the third quarter alone we had four billion dollars come in. That's equivalent to 20% of total outflows we saw from 2013 and the first half of this year," he says. "The only reason why anyone was buying U.S. and European debt was because of capital gains. Why risk it in risky EM? The whole asset class has been beaten up because of it. The S&P is up over 200% since March 2009. U.S. Treasurys are up about seven and EM has simply gone the other way. That's not normal."
Dehn flips through a thick packet of slides stapled together with the Ashmore logo in the upper right. Here's his case, based on a compilation of datasets from JP Morgan and MSCI as of Nov. 14: investors are tip-toeing in this year compared to last year, with local currency bonds beating the dollar-denominated ones. Stocks are up. Small caps are up. Both are beating the S&P 500. The trend is your friend.
Yields are better and bond investors will have to return to yield again instead of gunning for capital gains. Central banks are no longer the big buyer they once were, supporting major premiums over par value. As U.S. rates go up, those holding bonds prior to the increase are watching their bond values erode.
Meanwhile, investment grade emerging market corporate bonds pay around 4.12% for five-year duration and dollar sovereign bonds around the same for 7.3-year duration. Local currency bonds are better, with 6.23% yield for five year duration.
Interest rates in countries like Brazil and Russia are coming down, increasing the value of the higher yielding bonds Ashmore funds have been holding for years.
Two years ago, Dehn forecast that a strong dollar would turn investors to emerging markets. It didn't happen. A combination of strong growth at home kept the dollar stronger for longer. Only in the last 12 months are EMs seeing an increase of portfolio flows, according to EPFR Global in Cambridge, Mass.
Still, emerging markets -- for the most part -- are worth more now than they were two years ago. Whether or not that continues into 2018 depends on a number of factors, not the least being no surprise economic blowouts in Europe, the U.S., and China, a war with North Korea, or something similar in the Middle East between Saudi Arabia and Iran.
If Dehn is right, emerging market bonds will be a strong buy in 2018 among the institutional investors that manage pension funds and life insurance portfolios. After a long hiatus, countries that have been beaten up since the Fed's Taper Tantrum back in 2013 are becoming bonafide investment destinations again.
"It's a process," says Dehn about the investor committee meetings and legal paperwork institutional investment firms must go through before increasing allocation. Assuming it takes a good six months to decide on an asset class to build on, emerging bonds may be in their early innings. "We're expecting a very positive flow picture next year," he says.
