For Michael J. Conelius, the lead manager of T. Rowe Price’s $632 million emerging markets debt fund, Iraq has been the trifecta, even if the final payoff is yet to come.
In a recent interview, Mr. Conelius said his team typically looks for “diversification, restructurings and out-of-favor” situations, and on all three counts Iraq “bubbled up on our radar screens.”
T. Rowe took its first taste of Iraq in late 2005, when the country’s bonds were still in default, and subsequently raised the weighting of those bonds in the firm’s emerging market debt portfolio to 5% after a successful restructuring in early 2006.
Trading at 65 cents on the dollar, the Iraqi bonds, with a 5.8% coupon, yield roughly 10% — “about the highest yielding dollar instrument you can find” today, said Mr. Conelius.
After a four-year bull market that has brought the yield on emerging market debt down to a scant 170 basis points over U.S. Treasuries, finding attractive, uncorrelated returns is becoming more like a scavenger hunt, Mr. Conelius said. T. Rowe Price is “trying to find diversification in a world that is pretty short of diversification.” For example, the correlation between emerging market debt and equity markets has risen to 90%, he noted.
T. Rowe Price has bought unloved paper before. “Historically the best source of alpha in our markets has been restructurings, not trading,” Mr. Conelius said. Over the past six years the firm has bought other defaulted paper, such as Argentine and Uruguayan bonds, holding them for years before restructurings brought them back to publicly traded markets.
Those investments have helped the T. Rowe fund outperform its JPMorgan Emerging Markets Global index benchmark on a three- and five-year basis by 4.9 percentage points and 2.85 percentage points respectively.
Mr. Conelius insists he isn’t looking at Iraq through rose-colored glasses. “Things are very bad from a security standpoint,” and amid all of the violence there has been little investment in an oil industry that “needs tens of billions in investments.” Even so, Iraq’s long-term economic story is compelling, “if we can just get to the long term,” Mr. Conelius said. With only 2,300 oil wells drilled in Iraq, compared to more than a million drilled in the state of Texas, it takes only two days of exports to cover Iraq’s annual debt service, he noted.
“I’ve thought through the long-term logic of the position pretty carefully,” he said, and he wasn’t about to leave any stone unturned. Last July, the search for the road less traveled took Mr. Conelius to northern Iraq, even though he had to take out special insurance to make the trip. He said he was “mostly looking to meet the people, and get a sense of their commitment” to a unified Iraq ahead of important government votes on a hydrocarbon law and a referendum on the status of the oil-rich Kirkuk region in the Kurdish north.
“I came away with a mixed view,” said Mr. Conelius, although on balance Iraq will likely end up with a relatively weak central government that will distribute oil revenue to the provinces on the basis of population. “I think our end expectation is a weak central government, which is really all we need from a debt service standpoint.”
For now, Iraqi debt is “very much a medium-term investment.” Despite a relatively good yield, T. Rowe’s Iraqi position has been “dead money for the past year or so” as the overall emerging markets debt market continued to rally. “But that’s when you need to build positions, when it’s unloved,” Mr. Conelius said. When the situation improves enough that everybody begins looking at Iraq, that’s when the position will yield capital gains, he said.
