Emerging bonds say thank you, Ben

August 18, 2010

Last week the U.S. Federal Reserve may have lit a small fire under the emerging bonds market. Already boasting double-digit returns this year, bonds from the developing world are the hot ticket this year, contrasting with the lacklustre performance on stocks or commodities.

The Fed’s move is likely to increase this divergence in returns.

Essentially the Fed has decided it will reinvest proceeds from its maturing mortgage investments back into Treasury bonds, thus keeping market liquidity levels high and signalling to the world its belief that the U.S. economy is still weak enough to need financial stimulus.  Its action also leaves  investors staring at the prospect of near-zero interest rates in the United States and the industrialised world for another year or so.

Such monetary stimulus is usually a godsend for stocks — something investors such as Phil Poole of HSBC Asset Management liken to a “comfort blanket” for investors. In 2009 for instance emerging stocks  jumped 80 percent as global central banks unleashed torrents of liquidity onto world markets.  But Chart1this year investors have been wary of boosting allocations to stocks — fearing that robust growth in emerging markets will not shield their export-oriented companies from the impact of a U.S. slowdown.

That has kept the MSCI emerging market stock index flat this year while the U.S. S&P 500 index has lost more than 2 percent.

“In the current environment, when people are concerned about growth slowing, it should boost emerging fixed-income more than stocks,” Poole says.

The excess liquidity today is such, says Standard Chartered’s senior credit strategist Bret Rosen, that it is forcing investors to “suddenly love” even pariah credits like Argentina, which only recently finished restructuring debt after a $100 billion default a decade back. The premium weak credits like Argentina and Ukraine, pay over U.S. Treasuries to investors buying its bonds is today 200 basis points lower than May.

“All of a sudden people are hoping Argentina issue bonds so we can buy more,” Rosen says referring to expectations that Buenos Aires will soon return to international  markets.

Flows to emerging market bonds are already running at record levels this year around $50 billion and should end the year around $70-75 billion, JP Morgan predicts. More than half of this cash has gone to bonds denominated in local emerging market currencies such as the South African rand and Polish zloty — these securities which have returned around 9 percent so far this year, should gain further as inflation in the developing world is turning out lower than anticipated.

JP Morgan’s survey of investors showed recently that fund managers are actually sitting on cash balances of almost 5 percent of their portfolio. The meaning? Market technicals are positive, hinting at more gains for emerging market bonds once summer holidays are over.

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