One Sunday morning last fall, Michael Gomez left his wife and two kids at home to take an early walk along the sandy coves and beaches near Corona Del Mar, California. Gomez, who along with Curtis Mewbourne manages some $80 billion in emerging-markets bonds for Pacific Investment Management Co., had become unnerved as the subprime storm and its aftermath whipsawed values in his portfolios. As he paced the shore barefoot, he turned on his iPod and tuned in to Desolation Row and other Bob Dylan classics.
I was trying to bring it down a level and clear my mind, he says.
No wonder. Gomez didnt have to be a weatherman to know how hard the wind was blowing. Since taking over in early 2006 from their renowned predecessor, Mohamed El-Erian, Gomez and Mewbourne had presided over a portfolio that had more than doubled in size and grown far more complex with more than 60 percent of assets in local currencies, up from 15 percent. But their short-term performance, in the benign months before last summer, had been mediocre. Their risk-averse strategy favoring countries with strong external reserves and prudent macroeconomic policies left them trailing more aggressive investors.
Now, suddenly, markets for emerging-markets debt were moving in wild, often erratic patterns. And Pimcos portfolios were gyrating crazily, with some dollar-denominated external sovereign bonds strengthening as the U.S. Federal Reserve Board lowered rates, while corporate and local currency bonds were falling as market liquidity evaporated.
Volatility was hitting different asset classes in waves, says Mewbourne. One day we had a 20-standard-deviation move in implied volatility. Its like seeing Halleys Comet every couple of years instead of every 70-odd years.
Not long after his stroll on the beach, Gomez began meeting with Mewbourne on Sunday afternoons in the firms Newport Beach trading room to reexamine their long-term views and plot short-term tactical moves. In one adjustment, in October, they sold Brazilian and Venezuelan external debt, which had risen, and bought Philippine external debt, which they had been underweight. Earlier, Pimco had sold sovereign Ukrainian bonds and bought credit default swaps that paid an additional 65 basis points for five-year maturities. Given the volatility in the market, the extra compensation was really blown out, says Gomez.
Their decisions paid off, with peer rankings greatly improving as the year ended and the credit crisis deepened. Pimcos $4.4 billion Developing Local Markets Fund, which invests only in short-term local currency bonds, returned 13.2 percent in 2007, putting it in the top 1 percent of its peers, compared with the 22nd percentile in 2006, according to Morningstar. The $1.2 billion Emerging Local Bond Fund, which invests in longer-duration local bonds, returned 12.32 percent in 2007, a fifth-percentile performance, in its first full year of returns. The $3.1 billion flagship Emerging Markets Bond Fund, which focuses chiefly on external, dollar-denominated debt, posted a 5.6 percent gain last year, lifting it to the 33rd percentile from the 76th percentile.
Last month the pair won a strong endorsement for their stewardship when the World Bank chose Pimco over some 35 rival fund managers to lead its effort to invest $5 billion in local currency debt markets. Its a coup that allows Gomez and Mewbourne to step out of the shadow of the outspoken El-Erian, who returned to Pimco in early January as co-CIO and co-CEO after two years running Harvard Universitys endowment.
Theyve been able to maintain performance in a world that is more complicated than the world I grew up in, says El-Erian, who guided Pimco into the front ranks in emerging markets through shrewd investments and astute risk management. (He was nearly alone among major bond investors in having no exposure to Argentina when it defaulted in 2001.) They have built tremendously on what was there when I left.
Gomez and Mewbourne are quick to credit their mentor, El-Erian, noting that they continue to adhere to the approach they learned working alongside him. Still, they acknowledge that the operation has grown exponentially more complex. Until 2005, Pimco had only one emerging-markets fund; it focused on external debt, denominated chiefly in dollars. El-Erian who guided the Emerging Markets Bond Fund to an 18 percent annualized return from March 31, 2000, to September 30, 2005 moved Pimco into local-market debt. His successors made local currency bonds the portfolios mainstay, using derivatives to manage interest rate and foreign exchange risk.
Pimco may be a pioneer in emerging-markets debt, but as the heated competition for the World Bank mandate shows, the field is now getting crowded. Over the past two years, as money from institutional investors has poured into the sector, a raft of big players have rolled out their own local currency strategies, chasing Pimco, which has $79.6 billion, and London-based Ashmore Investment Management, which manages $34.6 billion. These two houses are trailed by ING Investment Management ($13.6 billion), JPMorgan Asset Management ($10.8 billion) and Stone Harbor Investment Partners ($8.8 billion), according to Darien, Connecticutbased consulting firm Rogerscasey.
Its a natural progression, says Timothy Barrett, CIO and executive director of the $6.3 billion San Bernardino County Employees Retirement Association in Southern California, who made an initial investment in emerging-markets debt in 2004 with a 2 percent allocation to a dollar-based fund run by Ashmore that is now at 4 percent, three quarters of it in local currencies. These economies are getting stronger and less dependent on the U.S. economy and the dollar.
Gomez and Mewbourne are hard-driving, palpably ambitious individuals, inured to starting before dawn and working long hours and on weekends. Both executive vice presidents, they are a tight team, often completing each others sentences. But the sources of the two mens motivations are worlds apart.
Gomez, 35, is the son of respected Colombian physicians who came to the U.S. in 1968 to provide better opportunities for their children. His father, a cardiothoracic surgeon who did the first heart transplant in Colombia, and his mother, a psychiatrist, had to repeat their medical residencies. Gomez was humbled by the work ethic of his father, who sometimes put in 48-hour stretches as head of intensive care at the Deborah Heart and Lung Center in Browns Mills, New Jersey. Gomez earned a bachelors degree from the University of Pennsylvania and an MBA from the Wharton School of Business. He worked one year as an adviser in Colombias Ministry of Finance, then traded Latin American bonds for Goldman, Sachs & Co. before joining Pimco in 2003.
Mewbourne, 41, was born in West Virginia, where his father worked in a glass factory. Financial success, he openly admits, is a major goal. Thats part of my ambition: the American dream, he says. After earning a bachelors degree in computer science engineering from the University of Pennsylvania, he worked as a financial consultant for Arthur Andersen and later joined Lehman Brothers as a market maker for emerging-markets debt. He then ran Salomon Brothers emerging-markets trading desk in London before El-Erian hired him in 1999.
Im usually in at 5:15 every morning and Im here for 12 hours, and Mike makes me feel like Im not putting in enough time, he says.
Their arduous efforts, though, could pay huge dividends as growth in emerging-markets debt outstrips that in developed markets. The $6.2 trillion pool of outstanding emerging-markets debt has grown about 18 percent annually for the past five years, compared with 10 percent annual growth for the $65 trillion in developed-world bond markets. Mewbourne reckons that the proportion of Pimcos assets made up of emerging-markets debt could double, to 20 percent, in five years.
So how do Gomez and Mewbourne view the current market crisis? In the short term they expect the U.S. to avoid a deep and protracted recession, thus averting damage to fast-growing emerging economies dependent on exports, and they think the dollar will continue to depreciate in an orderly fashion. But they are also convinced that the market will increasingly discriminate between the highest- and lowest-quality credits and currencies, particularly in countries that need financing from external markets. In 2008, as economies start to react to higher prices for oil and other commodities, the risks will be much more country-, duration- and corporation-specific, concurs Cynthia Steer, chief research strategist and head of fixed income for Rogerscasey.
Indeed, the credit crisis has underscored long-term trends that make Gomez and Mewbourne even more confident about investing heavily in emerging markets. A decade ago capital from the developed world, which tended to run current-account surpluses, funded deficits run up by emerging-markets nations. Now the opposite is true. China is the most obvious example, but natural-resource-rich Russia and fast-growing Brazil have also shored up their national accounts, strengthening their standing in the markets. About 41 percent of the market capitalization of the JPMorgan EMBI global index, an external debt index including 38 countries, is now investment grade, a ratio likely to rise to more than half this year if, as many expect, Brazil is upgraded. Increasingly, emerging-markets debt is issued in local currencies, and capital markets are deepening: Mexico, for instance, now has a 30-year bond denominated in pesos.
The Pimco executives believe that the rapid growth in local currency debt plays to the firms strengths as a behemoth bond house. Local markets put a premium on research, especially for corporate debt, and no one has a bigger team than Pimco. In emerging markets it fields eight portfolio managers and 30 credit analysts spread among its Newport Beach headquarters and London, Munich, Singapore and Tokyo.
Our size confers tremendous advantages, such as access to market information, access to decision makers, governments and corporations, says Gomez. These factors dont mean as much when theres an abundance of liquidity, but when things get tight they count a lot.
Adds Mewbourne: We want to grow our business to operate in new areas mortgage markets in Brazil and Mexico and do more corporate lending and bank loans. We think the way forward is to have a very big global platform.
Using a largely top-down, long-term approach based chiefly on secular forecasts of economies and markets, Pimco offers three discrete and dedicated emerging-markets strategies to its retail and institutional clients. One focuses on external debt. Two invest in local currency bonds, one with short-duration debt (making it essentially a currency play), the other with bonds of longer maturities. About 37 percent of the firms $80 billion in exposure is to external markets. About two thirds of the total is allocated tactically as part of multisector funds, such as Diversified Income and Floating Income, and institutional mandates. About 98 percent of its emerging-markets assets come from institutional clients.
Competitors say Pimcos size can be a disadvantage. If youre managing tens of billions of dollars, and you see an attractive option in a country like Egypt, its hard to take a meaningful position in your portfolio, says Edwin Gutierrez, a portfolio manager with Londons Aberdeen Asset Management. It invests in countries like Turkey, which Pimco shuns because it has a large current-account deficit. Emerging-markets specialist Ashmore has built a franchise with big exposure to riskier assets. In October it launched what it says is the worlds first emerging-markets corporate high-yield fund.
Now everybody and his dog is doing local currency debt, but its not straightforward, says Jerome Booth, head of research at Ashmore. Theres a whole bunch of things in addition to relationships with central banks and knowledge of the markets. Its complex and not something you can develop in a couple of years. Investors want to look at track records.
Mewbourne concedes that Pimco is less nimble than smaller players, but says that the firm has growing room to maneuver in markets that are rapidly expanding. Its emerging-markets bond portfolio is less than 1 percent of the total market, he notes. And, he says, in five or ten years, emerging-markets debt will be much larger than the 9 percent of total fixed income that it is today; it will probably be more than 20 percent.
Although Pimcos conservative strategy reduces volatility, its not without cost: Higher-quality assets generally come with lower yields, and sometimes the market takes a more sanguine view of risk. Turkeys bonds, for example, offer real, after inflation, yields of 9.5 percent, according to Daniel Tenengauzer, head of global currency strategy for Merrill Lynch & Co.
Perhaps because of the size of their portfolios, Pimcos managers often express their views in big ways. Gomezs and Mewbournes biggest bet is Brazil which has about 20 percent of the firms local currency exposure, or some $10 billion. Inflation is running at about 4 percent there, yet local debt issues maturing in 2012 are yielding close to 13 percent. By contrast, Pimco took its entire stake of $800 million off the table in Ecuador in 2006, shortly before the government nationalized the operations of Occidental Petroleum Corp. Gomez and Mewbourne say their goal is to hit not home runs, but singles and doubles that will yield steady returns in a volatile asset class. As institutional investors pile in, that strategy could make their prominence in emerging markets only greater.