Global Investing

Emerging local debt: hedges needed

The fierce sell-off that hit emerging market local currency debt last month was possibly down to low levels of currency hedging by investors, JPMorgan says.

Analysts at the bank compare the rout with the one May 2012, caused by exactly the same reason — higher U.S. yields. There was a difference though — back then EM currencies dropped more than 8% on the month but EM local bonds, unlike last month, were little changed.

Gauging hedging levels is usually a tricky business. But JPM uses the results of its monthly client surveys to analyse the differing moves:

Flows to EM local markets were muted throughout 2012 and investors regularly employed high FX hedge ratios of EM bond portfolios, but investors shifted stance in 2013…..EM FX hedge ratios were low entering the sell-off, having fallen below 10% relative to 25% in May of 2012.

 

The lower level of hedging gels with investors’ return expectations going into 2013, the bank said.  Its survey back in November 2012 revealed that investors expected total returns from local markets of 7-10% versus 5-7% for EM sovereign and corporate credit. And within local markets, investors were banking on currency appreciation to deliver around half the total returns.

South Africa’s perfect storm

Of all the emerging currency and bond markets that are feeling the heat from the dollar’s rise, none is suffering more than South Africa. A series of horrific economic data prints at home, the prospect of more labour unrest and the slump in metals prices are making this a perfect storm for the country’s financial markets.

Some worrying data from the Johannesburg Stock Exchange this morning shows that foreigners sold almost 5 billion rand (more than $500 million) worth of bonds during yesterday’s session alone. Over the past 10 days, non-resident selling amounted to 10.7 billion rand. They have also yanked out 1.2 billion rand from South African equities in this time. And at the root of this exodus lies the rand, which has fallen almost 15 percent against the dollar this year. Now apparently headed for the 10-per-dollar mark, the rand’s weakness has eaten into investors’ total return, tipping it into negative return for the year.

What a contrast with last year, when a record 93 billion rand flooded into the country on the back of its inclusion in Citi’s prestigious WGBI bond index.  That lifted foreign holdings of South African bonds to well over a third of the total. Investors at the time were more willing to turn a blind eye to the rand’s lacklustre performance, liking its relatively high yield and betting on interest rate cuts to help the duration component of the trade.

Not all emerging currencies are equal

The received wisdom is dollar strength = weaker emerging market currencies. See here for my colleague Mike Dolan’s take on this. But as Mike’s article does point out, all emerging markets are not equal. It follows therefore that any waves of dollar strength and higher U.S. yields will hit them to varying degrees.

ING Bank says in a note sent to clients on Tuesday that emerging currency gains in recent years have been closely tied to foreign investments into domestic bond markets. Recent years have seen a torrent of inflows into local debt, driving down yields on the main GBI-EM index and significantly boosting its market value. Hence, it makes sense to examine how the GBI-EM’s biggest constituents might fare under a scenario of a surging dollar and Treasury yields (In the two years before a Fed tightening cycle commences, 5-year Treasury yields can trade 120-150 basis points higher, ING analysts point out).

In almost every one of the emerging markets examined by ING, spreads over U.S. Treasuries have tightened dramatically since the start of 2012. Ergo, they are vulnerable to correction.

Emerging corporate debt: still booming

The corporate bond juggernaut continues apace in emerging markets.

In a note at the end of last week, analysts at Bank of America/Merrill Lynch estimated that companies from the developing world have sold debt worth $179 billion already this year. Originally, the bank had forecast $268 billion in corporate debt issuance in 2013, a touch below last year’s $290 billion but it is finding itself, like many others, marking up its estimates.

Oleg Melentyev,  credit strategist at BofA/Merrill, writes that recent bumper bond sales imply quarterly issuance is running at 10-11 percent of market size, well above the past average. Melentyev points out that the first 4.5 months of the year tend to account for 35 percent of full-year total debt sales by EM companies.  If this formula were applied now,  it would imply total 2013 new debt issuance at $420 billion.

For now, however, the bank expects $316 billion in full year corporate issuance from EM, with Asia accounting for $126 billion of this.

Turkey’s (investment grade)bond market

We wrote here yesterday on how Turkish hard currency bonds have been given the nod to join some Barclays global indices as a result of the country’s elevation to investment grade. Turkish dollar bonds will also move to the Investment grade sub-index of JPMorgan’s flagship EMBI Global on June 28.

Local lira debt meanwhile will enter JPM’s GBI-EM Global Diversified IG 15 percent Cap Index —  the top-tier of the bank’s GBI-EM index. But the big prize, an invitation into Citi’s mega World Government Bond Index, is still some way off. Requiring a still higher credit rating, WGBI membership is an honour that has been accorded to only four emerging markets so far.

Still, the Turkish Treasury is not complaining.  Even before last week’s upgrade to investment grade by Moody’s, it was borrowing from the lira bond market at record cheap levels of around 5 percent for two-year cash. Ten-year yields are down half a percentage point this year. One reason of course is the gush of liquidity from Western central banks. But most funds (at least those who were allowed to do so) had not waited for the Moody’s signal before buying Turkish bonds. So the bond market was already trading Turkey as investment grade.

Paid for the risk? Egypt’s tempting pound

Surprising as it may seem, the Egyptian pound has got some fans.  The currency has languished for months at record lows against the dollar and the headlines are alarming — the lack of an IMF aid programme, meagre hard currency reserves, political upheaval. So what’s to like ?

Analysts at Societe Generale say that just looking at the spot exchange rate of the pound is missing the bigger picture. Instead, they advise buying 12-month non-deliverable forwards on the pound — essentially a way of locking into a fixed rate for pound against the dollar in a year’s time depending on where you think it may actually trade. They write:

The implicit yield at this point is 21 percent for the 12m NDF, which we think is quite attractive. The way to think about Egypt NDFs is to approach them as a distressed asset. The risk/reward is quite attractive, and a lot of the bad news has been priced in. Yes, there have been serious delays in the programme negotiations with the IMF and that has clearly been a negative for the overall country view, but I would like to point out that the actual 12m NDF level has hardly budged in the process. This to me suggests that the valuation looks particularly good.

South African rand slides as labour unrest grows

The South African rand has lost most ground amongst emerging market currencies, according to Reuters data, falling almost 10 percent so far this year to hit 4-year lows against the dollar.

That is perhaps not so surprising given the country’s high level of dependence on the minerals and mining sectors, which have been disrupted by labour strikes along the same lines evident in the summer of 2012. Lonmin, the world’s third largest producer of metal, said it stopped its production of its Marikana mine near Rustenburg following strikes over wages.

 

Net commodity exports – Morgan Stanley and UNCTAD

With the metals and mining sectors accounting for 60 percent of South Africa’s exports, the strong relationship between these sectors and the rand is not surprising. A falling currency has a knock-on effect of facilitating inflation, especially as imports grew faster than exports for the first quarter of 2013. Meanwhile platinum prices have been in a gradual downwards trend since February.

Emerging European bonds: The music plays on

There seems to be no end to the rip-roaring bond rally across emerging Europe.  Yields on Turkish lira bonds fell to fresh record lows today after an interest rate cut and stand now more than a whole percentage point below where they started the year.

True, bonds from all classes of emerging market have benefited from the flood of money flowing from central banks in the United States, Europe and Japan, with over$20 billion flowing into EM debt funds since the start of 2013, according to EPFR Global. Flows for the first three months of 2013 equated to 12 percent of the funds’ assets under management.

But the effect has been most marked in emerging European local currency bonds — unsurprising, given economic growth here is weakest of all emerging markets and central banks have been the most pro-active in slashing interest rates.  Emerging European yields have fallen around 50 basis points since the start of the year, compared to a 20 bps average yield fall on the broader JPMorgan index of emerging local bonds, Thomson Reuters data shows.

Japan’s big-money investors still sitting tight

More on the subject of Japanese overseas investment.

As we said here and here, Japanese cash outflows to world markets have so far been limited to a trickle, almost all from retail mom-and-pop investors who like higher yields and are estimated to have 1500 trillion yen ($15.40 trillion) in savings. As for Japan’s huge institutional investors — the $730 billion mutual fund industry and $3.4 trillion life insurance sectors — they are sitting tight.

If some are to be believed, the hype over outflows is misguided. Morgan Stanley for one reckons Japanese insurers’ foreign bond buying may rise by just 2-3 percent in the next two years, amounting to $60-100 billion. Pension funds are even less likely to re-balance their portfolios given large cash flow needs, the bank said.

But a Reuters survey last week revealed several insurance companies are indeed considering boosting unhedged foreign bond holdings.  Insurers currently hold almost half their assets in Japanese government bonds and risk being crowded out of the JGB market as the central bank ramps up purchases.  A recent survey by Barclays also showed Japanese investors keen on overseas debt.

Tokyo Sonata calls the tune for investors

The jury may be out on whether Messrs. Abe and Kuroda will succeed in cajoling the Japanese economy from its decades-long funk but the cash is betting they will. Domestic and foreign investors have stampeded for Tokyo equities, and Morgan Stanley has been crunching the numbers.

Since 2005, Japanese investors built up a 14 trillion yen (over $140 billion) portfolio of foreign equities. But between January-March 2013, they offloaded a third of this — about $39 billion.  Going back to July 2012 when they first started bringing cash home, the Japanese have sold $53 billion in foreign equities, or 36 percent of equity holdings.

If one were to include all foreign portfolio investments, they sold a net $74 billion worth of assets in the first three months of 2013. Morgan Stanley says this is the the most since 2005. You can see their graphic below (click on it for a bigger version).