U.S. Treasury headwinds for emerging debt

February 5, 2013

Emerging bond issuance and inflows have had a strong start to the year but can it last?

Data from JPMorgan shows that emerging market sovereigns sold hard currency bonds worth $9.6 billion last month while companies raised $51.2 billion (that compares with Jan 2012 issuance levels of $17.5 billion for sovereigns and $23.9 billion for corporates). Similarly, inflows into EM debt were well over $10 billion last month, very probably topping the previous monthly record,  according to JPM.

But U.S. Treasury yields are rising, typically an evil omen for equities and emerging markets. Ten- year U.S. yields, the underlying risk-free rate off which many other assets are priced,  rose this week to nine-month highs above 2 percent. That has brought losses on emerging hard currency debt on the EMBI Global index to  2 percent so far this year. (there is a similar picture across equities, where year-to-date returns are barely 1 percent despite inflows of around $24 billion). Historically, negative monthly returns caused by rising U.S. yields have tended to lead to outflows.

The S&P500 U.S. equity index is trading at five-year highs, however, despite Treasuries’ creep higher. That would appear to indicate greater confidence in the growth outlook.  Support for emerging markets may also come from Japanese retail cash that is fleeing a falling yen. Morgan Stanley analysts, for instance, do not expect significant outflows just yet, noting that “the nature of inflows overall (into emerging debt) has been more structural than in past years and therefore tends to be much stickier”. They add:

We believe that EM investors should not be overly concerned. The main reason for this is the expectation of a range-bound UST going forward, with only 25 bps further widening projected. Neither the pace nor the extent of this change seems disruptive to us, even with a potential temporary overshoot on the upside.

But some steps to protect returns look warranted. MS analysts, for instance, noted that 60 percent of the sovereign debt index is made up of investment grade credits that trade at very tight spreads over Treasuries (see their graphic below). They recommend positioning in longer-duration 10-year bonds especially in high-beta, higher-yield names that offer more of a spread cushion to Treasuries.

JPMorgan analysts also advise holding onto overweight positions in emerging dollar debt.  They suggest focusing on corporate debt rather than sovereigns because of the yield pick-up. Within the sovereign asset class, higher-yield names such as Venezuela could prove a better bet in the current Treasury environment instead of stronger, low-beta credits such as Brazil, whose yield attraction diminishes as Treasury yields rise, JPM says. They also reckon the current Treasury sell-off is a temporary one, as likely budget spending cuts looming after March 1 will constrain debt supply from the United States.


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