Standard Life Investments’ (SLI) hugely successful Global Absolute Return Strategies (Gars) team has piled into emerging market bonds with a new investment in Brazil.
The team behind one of the biggest funds in the IMA universe has established a position in Brazilian government bonds in both its conventional and index-linked debt.
Roger Sadewsky, an investment director in SLI’s multi-asset team, said the team was looking at opportunities in other emerging markets to add to the new Brazilian position and holdings it already has in Mexico.
Mr Sadewsky said Gars had opened the position in local currency Brazilian bonds to benefit both from their high yields and any move by the Brazilian central bank (BCB) to cut its interest rate.
The BCB has spent the past few years tightening its monetary policy, in part to keep inflation under control.
The policy has resulted in the Brazilian interest rate currently standing at 11 per cent, higher than most other economies in the world.
Mr Sadewsky said the conventional government bonds that Gars had been buying had a yield in excess of 12 per cent.
Even when adjusted for inflation, the bonds have a real yield of approximately 6 per cent, a high return in the current environment of ultra-low rates in the western world.
But Gars is also hoping for some capital growth from the position in addition to the yield, because it expects the BCB to cut the interest rate soon, which is likely to increase the value of government bonds.
Mr Sadewsky said: “Given the proactive nature of the rate hikes and the underlying weakness in the Brazilian economy, the bonds look very attractive.”
The manager said he is “expecting rate cuts in Brazil, though not until they tame inflation”. He predicted the first cut could happen within a few months.
In spite of buying local currency bonds instead of hard currency bonds, which are denominated in dollars, Mr Sadewsky said the Gars team had hedged away its exposure to the Brazilian real.
He said: “We feel the currency is a risk so we have hedged it out. It means we have less carry, but what we do own are very high yielding bonds that could see a rate cut at some point.”
Apart from Brazil, Gars also has positions in both Mexican government bonds and the Mexican peso.
“We are looking at other markets at the moment, but Brazil and Mexico stood out for us,” said Mr Sadewsky.
He said the Gars managers were finding “more opportunities in emerging markets generally” but were “treading very carefully”.
Mr Sadewsky warned that in some countries the currency just adds risk, but if you hedge out the currency you are left with very little in terms of yield.
He also pointed out that the withdrawal of quantitative easing (QE) and an eventual rise in the US interest rate “could leave some emerging market countries exposed”, recalling the sell-off in emerging market assets in 2013 when then Fed chairman Ben Bernanke first hinted that QE may be coming to an end.
Gars looking to reduce exposure to developed market credit
While it has recently been buying emerging market bonds, the Gars fund has been reducing its exposure to developed market credit and is likely to keep cutting.
Roger Sadewsky last week said the Gars team had been “slowly dialling down credit exposure” on the fund in recent times.
The exposure to high yield bonds was the first to be reduced, well before US Federal Reserve chairman Janet Yellen suggested there may be valuation concerns on the asset class.
But Mr Sadewsky said the team had also made some “minor changes” to reduce its exposure to investment grade credit as well.
He also questioned whether investors were being paid a sufficiently high premium for the risks involved in credit, especially with the potential for liquidity issues if investors start selling out en masse.
Mr Sadewsky said: “Credit still has a high probability of generating a low-ish return, so there may be a place for it in the portfolio, and indeed we have some, but it is an area we will be looking to reduce rather than add to.”
