Emerging market debt used to be the ultimate contagious asset class. A sneeze in one country could send shivers across entire regions.
In the 1990s, tentative economic problems in Asia worsened dramatically as investors stampeded for the exits. Soon after, Russia’s debt default sent bondholders elsewhere running for cover once more.
Yet despite the recent credit market turmoil in the US, emerging market debt is currently outperforming other types of bonds.
Since early March, the average spread of emerging market bond yields over US Treasuries has risen by almost 50 basis points, according to JPMorgan, compared with about 180bp for high yield corporate debt.
Those following emerging markets are not surprised, however.
“Emerging market bonds offer higher yields and better credit ratings momentum than core debt markets such as the US – in particular, better momentum than corporate credits where the cycle is turning negative,” said David Spegel, emerging markets strategist at ING Financial Markets.
The downgrades of General Motors and Ford – and their anticipated exit from Lehman Brothers’ widely followed investment grade bond indices at the end of the month – could directly benefit emerging market countries. Mexico, for example, is now the biggest single BBB-rated credit in the index, meaning those investors closely tracking index weightings will be forced to raise their holdings.
The spread, or yield differential, between Mexican medium-term debt and BBB corporate credits has narrowed from 75 basis points in early April to 35bp this week, according to JPMorgan data.
As much as 40 per cent of the emerging markets universe is rated investment grade. The investment grade vacuum created by GM and Ford’s slide to high-yield status could particularly benefit high-grade emerging markets if investors continue to shy away from corporate bonds. Already, the spread between emerging markets rated BBB and equivalent high-grade corporate bonds has narrowed from about 50bp in early April to almost zero today.
In the longer term, analysts say emerging markets’ buoyancy is also the result of a shift in investor attitudes. Once the domain of specialist investors, the higher yields and improving fundamentals have encouraged staid pension funds and fast-moving hedge funds to buy into emerging markets.
Relatively strong economic fundamentals have also helped support investor confidence.
High commodity prices have lifted the exports and earnings of a number of individual countries and bolstered emerging market debt as a whole.
There are, however, regional risks. Investors in eastern Europe, for example, have become cautious as the French referendum on the European Union constitution looms with a No vote quite possible.
“For the CEE4 [Poland, Hungary, the Czech Republic and Slovakia] it is not so big since they’re pretty much on track for euro entry. But there’s a heavier question for those that are yet to begin the accession track,” said Mr Spegel.
New issuance is patchy and not expected to pick up much, a factor also supporting demand. Last week, Brazil and Uruguay took advantage of the market’s strength to tap investors for $500m and $300m, respectively.
“The deals were done at a wider spread, but both did get done,” noted Enrique Alvarez, Latin American fixed income strategist at IDEAGlobal in New York. “Countries are being cautious in approaching the market, but we know too that no one in that region is really pressed to borrow at this point.”
However, emerging markets are not entirely free of the negative effects of GM and Ford. “Everyone is worried about hedge fund portfolio contagion right now,” said Gary Kleiman of Kleiman International, a Washington-based emerging markets consultancy.
Rumours of large hedge fund losses related to GM and Ford trades are still swirling around the markets, and speculation is growing that funds in trouble could be forced to sell profitable trades, such as emerging market debt positions, to cover losses elsewhere.
“US mainstream hedge funds with some emerging market exposure are usually into Latin America since they’re based here,” added Mr Kleiman.
Mr Alvarez said lingering concerns about the potential for further downgrades of Ford and GM debt could weigh on market sentiment for some time yet.
“There is the potential for a ripple effect into Latin American markets and that’s an unknown that could cap the market for now,” he said.
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