As this eventful year draws near its conclusion, Meet the Street takes stock of how some funds focused outside the U.S. have performed. Today we check in with Jan Faller and Jack Janasiewicz, lead portfolio manager and co-portfolio manager, respectively, of (SCEMX) - Get Report Scudder's Emerging Markets Income S fund. Year to date, this volatile fund is up 8.8%, while its benchmark, the J.P. Morgan Global Emerging Markets Bond Index Plus, is down 1.4%.


Jan Faller,
Lead Manager,
Scudder Emerging Markets Income Fund

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Faller and Janasiewicz describe the challenges in this year's bond market, including the troubles in Argentina. Overall, though, they see much opportunity in Latin America as well as in Russia, the latter of which has come a long way since the crisis of 1998 and has emerged as one of the strongest performers in the global market this year. Find out what's powered the two managers' strong performance this year, and what they're expecting in the future.

TSC: First of all, could you briefly describe your investment philosophy and criteria, given that you focus on the debt side of emerging markets?

Faller: We try to look at investing for our fund within the risk-return framework. We wouldn't look at either factor in a vacuum. So the key question is with what kind of returns are we compensated for the levels of risks we take? We spend a lot of time thinking about anticipated returns and historical levels of volatility, as well as forecasting volatility going forward.

This has been an extremely unusual year. Generally, the most dominant driver for emerging markets' debt is market direction. At times, it doesn't matter which country you own -- country correlations are very high. But in the spirit of things, and as long as you get the direction of the market right, you will do well. You will either be overweight or underweight the market, and that is the dominant driver of your return.

We also consider factors such as global liquidity and commodity prices, risk appetite and actions taken by central banks. Consideration of these factors will lead us to an opinion about the direction of the market in general. The last six months have been quite unusual, because this hasn't really been true. That is due to Argentina being effectively decoupled from the rest of the index.

The next layer in this process of understanding the return side of the equation is country selection. This is generally a second-order question, after the market direction. But in the last six months, it has become a first-order question with regard to Argentina. We start looking at specific situations within each country. After this, we move to the third driver of performance, which is securities selection. This includes yield-curve management question, type of issuance, etc.

TSC: Could you talk us through your performance year to date? Has it adhered to your expectations?

Janasiewicz:

There were three big chances to make money. At the beginning of this year, the market was flush with liquidity. And just by being fully invested in the market, you were able to get enough return out of the market to be where you wanted to be. But to take a step further, higher-yield credits outperformed the market up to the first quarter of this year.

This meant being long the Ecuadors, Brazils and Russias of the emerging markets universe, and the fund benefited by being overweight in these countries. By midyear, however, Argentina became the focal point of the market. We began to see some cracks in the political cohesion in Argentina. We also saw the volatility in bond prices increase dramatically relative to their historical levels.

At the time, we felt that it wasn't a matter of default quite yet. There seemed to be potential that Argentina could muddle its way through. The markets, however, started to price in the default risk more than we anticipated, and bond prices started to come off.

Subsequently, in June, we saw Argentina come out with a mega debt swap. The market had a massive short squeeze, and investors were front-running this debt exchange. Typically, when there is a swap or debt exchange, the government will pay the bondholder a premium to the market price to take those bonds out of the market, and in return issue something cheaper on the curve. The fundamental outlook started to deteriorate at this time, and by the third quarter, we cut down on our exposure to Argentina.

While Argentina has been the worst-performing credit, if you take out Argentina's total returns from the total returns for the index, you are looking at hefty gains in the overall market. So it paid to be fully invested in the market despite the Argentina-related volatility.

There was serious concern for a kind of contagion from Argentina's default, or float of currency, affecting countries like Mexico or Brazil. However, as mentioned earlier, we have seen the decoupling or separation of Argentina, which is trading on its own. Any impact from a real default -- which could come before this year ends -- would be a knee-jerk reaction, and we would see that as a buying opportunity.

TSC: Which countries and sectors have you liked so far this year?

Janasiewicz:

We have been focusing on Russia. From the fundamental standpoint, the country continues to be an improving credit. And we have seen a significant pickup in spread-tightening. Rating agencies have upgraded Russia's debt three times this year.

From our point of view as bondholders, come maturity time or come coupon payment time, the bottom line is that we need to be paid. Back in 1998, Russia had about US $12-$13 billion in reserves. The reserves have skyrocketed from that time, and now Russia has accumulated over US $30 billion in reserves. President Vladimir Putin has also worked to implement a good fiscal policy and to push forward reform.

With Paris Club

a consortium of lenders of sovereign debt lending to Russia, for example, we are seeing Russia's commitment for those loans from the Paris Club, and the government has even made some payments ahead of schedule.

Initially, there were some questions after emerging from the crisis of 1998 as to the willingness of Russia to honor fiscal responsibilities. Now, investors have increasingly become comfortable with Russia's credit. And it's been one of the strongest performers in the last two years, and it has paid off handsomely for our fund.

TSC: What do you anticipate for next year in terms of global market conditions, especially with respect to the U.S.?

Janasiewicz:

Global liquidity is an important issue going forward. The U.S. is obviously a significant driver of global liquidity. So if the U.S. does well, the global environment will be helped. With a significant portion of the emerging market debt out of Latin America, the ties between Latin America and the U.S. are very important in promoting growth.

With rates as low as they are around the world, we're seeing potential recovery, at least in Europe's growth, and it bodes well for Latin America. Because the region relies heavily on commodity exports, you need buyers on the other side. So growth in countries such as the U.S. and those in Europe will help the economy in the region as well.

One caveat in the short term, however, is Argentina. The last leg to fall will come with its currency. We're likely to see the dollarization or even the float of the currency. But once we work through this problem, we believe that the resolution of this crisis will unlock value in the region. Right now, some investors are hesitant to bring money in the region, until they see that last shoe drop in Argentina.

Emerging markets are attractive because of the spreads at which they trade. The hefty coupons and yields that you get with these bonds provide a nice cushion against the significant volatility that you may get with bond prices. You're looking at about 10% yield in many of the countries we invest in.

Keeping the U.S. Treasuries and bond price static, if we start the year with about an 800 basis-point spread with the Treasuries and end the year at a similar spread level, we are talking about 11%-12% of total returns. That's a nice cushion to have.

Given that we expect to see some kind of recovery in the global economy, although a rapid recovery in the first or second quarter is debatable, we're likely to see a reversal of the trend toward a slower economy. We expect a decent market for emerging markets bonds next year, once Argentina gets itself out of the way.