Such diligence would have been pointless a few years ago when emerging markets moved in tandem. If Chinese bonds fell, Mexican ones would too, even if Mexico's economy was fine. But the past three years have seen a "decoupling" of emerging markets, so investors now see them as separate entities. After the Russian debt crisis of 1998, the International Monetary Fund began publishing detailed credit reports on each market, and countries realized the importance of communicating with creditors. "With more access to information and analysis, investors can differentiate better between countries," says El-Erian. That's a skill he honed in the 14 years he worked at the IMF where "you get to see how policymakers in these countries think and what measures are at their disposal." El-Erian is a New York-born economist who attended Oxford and Cambridge on scholarship.
The decoupling trend was sharply evident in 2001. Argentine bonds, which had a 22% weighting in the J.P. Morgan Emerging Market Bond Index, plummeted 66.9%, yet the 16 other emerging markets that the index tracks all rose--from a 5.5% gain for Venezuela to 55.8% in Russia.
The wide variations allowed El-Erian, who actively shifts between countries, to stand out. His fund rose 27.6% in 2001, more than double the average emerging-market bond fund's 10.6% total return. And its 25.8% three-year annualized return (as of Jan. 21) beats any other retail bond fund. Besides the $135 million fund, he runs $6.4 billion for institutional clients. Lately, he's been buying Panama's bonds, which he sees as relatively safe and cheap, and selling Russia's, which may be vulnerable to a decline in oil prices.
El-Erian sees emerging markets in three tiers. First-tier countries, such as Mexico and Poland, have learned from the currency crises of the 1990s. Anchored economically to more industrialized partners, such as the U.S. and Germany, they've improved their balance sheets and raised their foreign currency reserves. El-Erian invests most of his portfolio in this tier. The bonds tend to have higher credit ratings and lower yields than those of other markets. Mexican sovereigns, for instance, yield 7.5% and are rated BBB, vs. the 11.5% yield and BB- rating for the benchmark. "Mexico has accumulated significant international currency reserves, and it has pre-financed its debt for 2002," he says.
At the other end of the spectrum are third-tier markets such as Argentina, which in January defaulted on its debt. El-Erian anticipated that 18 months ago and sold the bonds. "Argentina established a currency pegged to the U.S. dollar without the willingness to accept the discipline that comes with that," he says. Others in the tier include Ukraine and Ecuador, whose bonds now yield 14% and 16%, respectively.
Between the first and third tiers are such nations as Brazil and the Philippines. Their bonds have high yields but are less volatile than the third tiers. Brazilian sovereigns, for instance, yield over 13% because of fears of contagion from Argentina, Brazil's biggest trading partner. El-Erian thinks these worries are largely unfounded, so he holds a 25% Brazil position, a neutral weighting relative to his benchmark. Yet he realizes that conditions could change overnight. That's why he walks his dog hours before the sun comes up. By Lewis Braham