Emerging markets land top of managers' portfolios with rising rates

By David Randall

NEW YORK (Reuters) - Rising short-term interest rates in the United States are prompting Lipper Award-winning bond fund managers to add emerging-market debt and non-agency backed residential mortgages that they say offer more potential for gains in the year ahead.

Managers from firms including AllianceBernstein, BlackRock Inc (NYSE:BLK) and Thornburg Investment Management are bracing for further rate increases by the Federal Reserve, making U.S. high-yield debt unattractive as highly-leveraged companies and municipalities have a more difficult time rolling over their debt costs.

Instead, managers say, emerging-market debt in countries like Brazil and Mexico that have slowly-stabilizing economies and are undertaking structural reforms, as well as municipal debt issued by cities like Dallas that are in the center of strong regional economies, look more promising.

"We are in a phase where diversification is going to be a big strategy" because there are fewer attractive assets given rising rates, said Gershon Distenfeld, portfolio manager of the AllianceBernstein High Income fund . "Our fund was up 15 percent last year and we don't see that happening again."

Distenfeld said that he now has about 40 percent of his portfolio invested in the United States, compared with 75 percent at this time last year. He has been moving chiefly into both dollar and local-currency denominated securities in Brazil.

U.S. high yield, by comparison, is "on the rich side now," he said. High-yield debt, for instance, suffered steep losses as investors moved to safer assets during Tuesday's stock market sell-off, while emerging-market debt retained more of its value.

The Fed raised short-term interest rates for the second time in three months on March 15, and is widely expected to tighten again at least two more times this year. Rising interest rates push down the price of older bonds with lower rates, eating into the returns of bond funds.

Mexico looks attractive given its economic reforms, said Bob Miller, the lead portfolio manager of the BlackRock Total Return fund . The peso is regaining value following a steep decline after the unexpected victory of U.S. President Donald Trump, Miller said.

He added that concern about more aggressive trade negotiations between the United States and Mexico "seems to have calmed down to a reasonable degree."

Miller remained optimistic about the strength of the U.S. economy. "There's no obvious imbalance" that could point to a coming recession, he said.

Not every Lipper Award-winning bond fund manager is so upbeat, however. Steve Kane, portfolio manager of TCW Core Fixed Income fund , said that he has just 2 percent of his fund in high-yield debt, and near zero of his fund in emerging-market debt, because he expects that the U.S. economy is near the end of its expansion and a recession is becoming more likely.

He is still finding value in non-agency residential mortgages, however, because he sees "continuing improving fundamentals even if we reach an economic downturn" thanks to rising home prices and wage growth, he said. He has also been buying triple-A rated commercial mortgage-backed securities that have been hurt by concerns about declining mall traffic in the age of online shopping.

"We are concerned like a lot of folks with the decimation of bricks and mortar retail, but we don't think we will see significant losses at the triple-A level," he said.

Chris Ryon, co-portfolio manager of the Thornburg Intermediate Municipal Funds , said that he had been buying shorter-duration bonds and focusing on higher-quality issues as interest rates rise.

He has been buying general-obligation bonds issued by some lower-rated cities such as Dallas and Chicago, however, because he sees the issues that have led to their lower credit ratings as more political than economic in nature.

"They have strong economies and an ability to pay," he said.