Eaton Vance’s Gaffney sees opportunity in emerging market-denominated bonds

By Kate Duguid

NEW YORK (Reuters) – There are untapped opportunities in corporate debt securities denominated in emerging-market currencies, Eaton (NYSE:) Vance’s director of diversified fixed-income said at the Reuters Global Investment 2019 Outlook Summit on Friday.

Kathleen Gaffney has put 30 percent of her fund’s $850 million in assets under management in non-dollar denominated debt. “Most fixed income investors don’t think about currency, and that could be the key to outperforming in 2019,” she said.

Emerging market currencies have been battered this year as the U.S. dollar has rallied on strong economic fundamentals and investor flight-to-safety as trade tensions and geopolitical uncertainty have risen. But with the MSCI International EM Price index down more than 15 percent this year, Gaffney said she is betting there is little room left for emerging-market currencies to fall.

Gaffney’s fund currently holds assets priced in Mexican pesos, Brazilian reais, Indian rupees, Indonesian rupiah as well as some in Turkish lira. She also cited commodity-backed currencies like the Australian, Canadian and New Zealand dollars as an effective hedge against inflation.

“In emerging markets, you have the two pillars of positive fundamentals: reform potential and currency, that if the dollar depreciates could be a good source of fixed-income returns,” Gaffney said.

An inflation surprise in the year ahead, she expects, will end the dollar rally. The U.S. unemployment rate currently stands at a 49-year low of 3.7 percent, and wages recorded their largest annual gain in 9-1/2 years in October as U.S. job growth rebounded sharply. Even if the Federal Reserve continues to hike interest rates, the tight conditions of the labor market could nevertheless spur a rise in inflationary pressures.

Although the Fed is now tightening monetary policy, the seven-year period during which rates were at zero created a swath of over-valued companies in the U.S. market, Gaffney said. The easy access to credit led some to load up on leverage, which investors, starved for yield, eagerly soaked up.

With corporate leverage at all-time highs and the Fed raising the cost of borrowing, “you have to now pay more attention to what you’re buying in investment grade credit. The focus has to return to company fundamentals,” said Gaffney.

This security-specific approach to investing has kept Gaffney out of credits which have fallen sharply as liabilities, poor returns or sector weakness has come to light: General Electric (N:), PG&E Corp (N:) and Tesla Inc (O:).

As the economy nears the end of this business cycle, credit duration “is now a headwind rather not a tailwind,” she said. Fixed-income investors who stick to traditionally attractive credit – long-duration investment-grade – without evaluating the fundamentals of the specific security are likely to perform poorly, said Gaffney.

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