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Emerging Markets Debt Fund —
EM debt markets post modest advance for 2014 after Q4 decline
4th Quarter, 2014
"Lower oil prices are not uniformly bad for the market. Lower oil prices mean lower inflation; that means more room for easing, which should be positive for growth. "
– Stone Harbor Investment Partners LP

Emerging markets debt securities lost ground in the fourth quarter of 2014 but managed a modestly positive return for the full year. Bonds from developing economies returned -3.15% for the fourth quarter and 0.68% for the 12 months ended December 31, 2014, as measured by a blended index composed of 50% each of the JPMorgan Emerging Markets Bond Index-Global Diversified Index, and the JPMorgan Government Bond Index-Emerging Markets Global Diversified.
Despite their fourth quarter weakness, emerging markets bonds outpaced international equities for both the quarter and full year. Emerging markets stocks returned -4.50% for the quarter and -2.19% for the year, as measured by the MSCI Emerging Markets (ND) Index, while equities in developed overseas markets posted returns of -3.57% for the fourth quarter and -4.90% for the year, as measured by the MSCI EAFE (ND) Index. At the same time, emerging markets debt lagged behind the broad U.S. taxable bond market, which returned 1.79% for the fourth quarter and 5.97% for the full year, as measured by the Barclays U.S. Aggregate Bond Index.
The Harbor Emerging Markets Debt Fund returned -5.16% for the fourth quarter, trailing the blended index. The Fund is managed by Stone Harbor Investment Partners. Above-benchmark exposures to debt securities in Venezuela and Russia hurt Fund returns relative to the blended benchmark, as markets reflected worries that falling energy prices could impair the debt-repayment capabilities of oil exporting nations, reports Whitney Cox of Stone Harbor. These factors were partially offset by favorable security selection in Argentina, Russia, Venezuela, and Kazakhstan, as well as a smaller-than-benchmark exposure to securities denominated in local currencies, which generally underperformed Dollar-denominated debt in the quarter. The Fund returned -2.97% for the full year, lagging the blended benchmark.
Whitney Cox's comments were made in a January 8, 2015, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended December 31, 2014, unless otherwise indicated. All references to year-to-date are for the period January 1 through December 31, 2014.

Interview Highlights

Local currency yield spreads
In our base-case scenario we believe local currency should outperform in the year ahead. We think local currency could deliver total returns of around 4% versus hard currency at 2.5% and corporates at 2%. Of course, the possible range of returns around those estimates is fairly large but we do expect local currency to outperform. Our view is that valuations, based on historical yield spreads between local currency and hard currency, are very attractive.
Effects of cheaper oil
Lower oil prices are not uniformly bad for the market. Lower oil prices mean lower inflation; that means more room for easing, which should be positive for growth. They are supportive for consumer spending. There are winners and losers in this situation; it is not all losers. Even at lower oil prices an issuer like Russia still has very strong credit quality.
Visiting Venezuela
Venezuelan debt right now is trading almost as if there were a near certainty of default. You’re looking at three-year paper that trades in the range of 40% yields; in our view this is extremely unrealistic, given the underlying credit quality of the country. We visited Venezuela a number of times in 2014, meeting with the finance minister, with members of the central bank, political opposition, and local banks. We came away with our convictions reconfirmed that this is a country that has both a strong ability and a willingness to pay its debt and is trading at levels that have been distorted by the market.
Portfolio changes
We added exposure to Russia, as there was a large sell-off in the market, particularly in the fourth quarter. We also added to credits that we continue to like, particularly Mexico, Paraguay, and Indonesia. At the same time we reduced exposure to credits that, in our view, had outperformed; Argentina, Chile, and Uruguay are examples of that. We added some exposure to the local currency side, particularly in Turkey, which we think could be a big beneficiary of lower oil prices.

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