Global Investing

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.

The IMF today advised Poland to continue cutting rates “without delay” to boost the economy. That should give another leg-up to zloty bonds, where short-dated yields are already at record lows.

The flows have also been a boon to troubled countries such as Hungary that might otherwise have scrabbled for money. Instead, Budapest had by end-April fulfilled more than 65 pct of its 2013 funding needs and has since indicated it might not need to tap international bond markets again this year.

Happy birthday EMBI! The index group, the main benchmark for emerging market bond investors, turns 20 this year.  When officially launched on Dec 31 1993, the world was a different place. The Mexican, Asian and Russian financial crises were still ahead, as was Argentina’s $100 billion debt default. The euro zone didn’t exist, let alone its debt crisis. Emerging debt was something only the most reckless investors dabbled in.

To mark the upcoming anniversary, JPMorgan – the owner of the indices – has published some interesting data that shows how the asset class has been transformed in the past two decades.  In 1993:
- The emerging debt universe was worth just $422 billion, the EMBI Global had 14 sovereign bonds in it with a market capitalisation of $112 billion.
- The average credit rating on the index was BB.
- Public debt-to-GDP was almost 100 percent back then for emerging markets, compared to 69 percent for developed markets.
- Forex reserves for EMBI countries stood at $116 billion
- Per capita annual GDP for index countries was less than $3000.
Now fast forward 20 years:
- The emerging debt universe is close to $10 trillion, there are 55 countries in the EMBIG index and the market capitalisation of the three main JPM indices has swollen to $2.7 trillion.
- The EMBIG has an average Baa3 credit rating (investment grade) with 62 percent of its market cap investment-grade rated.
- Public debt is now 34 percent of GDP on average in emerging markets, while developed world debt ratios have ballooned to 119 percent of GDP.
- Forex reserves for EMBIG members stand at $6.1 trillion
- Per capita annual income has risen 2.5 times to $7,373.

What next? The thinking at JPM seems to be that the day is not far off when a country “graduates” from the EMBI and joins the developed world.  To be excluded from the EMBI group of indices, a country’s gross national income must exceed the bank’s “index income ceiling” (calculated using World Bank methodology) for three years in a row or have a sovereign credit rating of A3/A- for three consecutive years.

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.

Emerging market currencies have been a source of frustration for investors this year. With central banks overwhelmingly in rate-cutting mode and export growth slowing, most currencies have performed poorly. That has been a bit of a dampener for local currency debt –  while returns in dollar terms have been robust at 13 percent, currency appreciation has contributed just 1.5 percent of that, according to JP Morgan.

The picture could be changing though.  Fund managers at the Reuters 2013 investment outlook summit this week have been unanimously bullish on emerging debt, with many stating a preference for domestic debt. So far this year, dollar debt has taken in three-quarters of all inflows to emerging fixed income.

Andreas Uterman, CIO of Allianz Global Investors told the summit in London that many emerging currencies looked significantly undervalued, and that this anomaly would gradually resolve itself:

Time was when investing in emerging markets meant buying dollar bonds issued by developing countries’ governments.

How old fashioned. These days it’s more about emerging corporate bonds, if the emerging market gurus at JP Morgan are to be believed. According to them, the stock of debt from emerging market companies now exceeds that of dollar bonds issued by emerging governments for the first time ever.

JP Morgan, which runs the most widely used emerging debt indices, says its main EM corporate bond benchmark, the CEMBI Broad, now lists $469 billion in corporate bonds.  That compares to $463 billion benchmarked to its main sovereign dollar bond index, the EMBI Global. In fact, the entire corporate debt market (if one also considers debt that is not eligible for the CEMBI) is now worth $974 billion, very close to the magic $1 trillion mark. Back in 2006, the figure was at$340 billion.  JPM says:

It’s turning out to be a great year for emerging debt. Returns on sovereign dollar bonds have topped 10 percent already this year on the benchmark EMBI Global index, compiled by JP Morgan.  That’s better than any other fixed income or equity category, whether in emerging or developed markets. Total 2012 returns could be as much as 12 percent, JPM reckons.

Debt denominated in emerging currencies has done less well . Still, the main index for local debt, JPM’s GBI-EM index, has  racked up a very respectable 7.6 percent return year-to-date in dollar terms, rebounding from a fall to near zero at the start of June.  Take a look at the following graphic which shows EMBIG returns on top:

Fund flows to emerging fixed income have been robust. EPFR Global says the sector took in  $16.2 billion year to date.  JPM, which tracks a broader investor set including Japanese investment trusts, estimates the total at $43 billion, not far off its forecast of $50-60 billion for the whole of 2012.

Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.

There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.

Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes: