InvestmentsApr 10 2014

Crimea crisis prompts Aberdeen EM team to cut Russia

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Aberdeen’s emerging market debt team slashed its exposure to Russia, as tension between president Vladimir Putin’s government and Ukraine escalated in Crimea.

The UK retail £68m Aberdeen Emerging Markets Bond fund had a 9.8 per cent weighting in Russia at the end of February this year, but Brett Diment, head of the team, said he had slashed that exposure as soon as the crisis began.

He said the case for bond investing in Russia had been that growth was weak and inflation was falling – an environment conducive for bond markets as it could lead to interest rate cuts.

But that investment case was harmed due to the events in Crimea, so the Aberdeen team reduced its weighting in Russian debt to 4 per cent.

“Inflation will be higher now as a result of economic sanctions so rate cuts will not be forthcoming,” Mr Diment explained.

“Russia also needs more foreign direct investment, but that is less likely given what has happened.”

In spite of its overweight position in Russia, the Aberdeen fund has significantly outperformed its peers in the past year.

The fund had a lower duration than its benchmark, the JPM EMBI Global Diversified index, going into May 2013, when the market suffered a massive fall after the US indicated it was planning on slowing its monetary easing.

Having a duration of 1.8 years below the seven years on the benchmark meant the fund was taking on less interest-rate risk, so fell by less than the index.

The fund also hedges out a lot of its emerging market currency exposure, which has helped its performance as most emerging currencies have depreciated compared to sterling in the past year.

From the peak of the market on May 22 2013, the average fund in the IMA Global Emerging Market Bond sector has fallen 13.9 per cent, while the Aberdeen fund has only fallen 4.2 per cent.

The emerging market debt market was being viewed as expensive prior to the May 2013 correction, but Mr Diment said that compared to the rest of the fixed income market, emerging market debt now looked cheap.

Strategic and global bond managers have recently begun allocating more money to emerging market debt and Mr Diment said he had also seen a pick-up of inflows recently, mainly into the offshore fund.

The fund has had a significant overweight position relative to its benchmark index in Brazilian debt for some time, although Mr Diment acknowledged the position had not yet paid off, but said he had continued to add to it as the market continued to weaken.

He said investors could now find a real yield – the money earned after inflation – of 7 per cent in Brazil, which he said was attractive.

Brazil has gone through a cycle of hiking interest rates to control inflation but Mr Diment said the negative headwinds would abate and predicted that bond yields could drop by 1 per cent in the next 12 months, which would produce strong capital gains for bondholders such as Aberdeen.

The fund will need to see those capital gains come through because the cost of hedging the currency from the Brazilian real to sterling costs 10 per cent of each individual holding due to the high interest rates in Brazil.

The Aberdeen fund hedges out all of the currency risk in the fund except for positions in India, Mexico and Uruguay. This is aimed at giving the fund a less volatile and more stable return profile, but it can be expensive to implement.