South African bond rush
It’s been a great year so far for South African bonds. But can it get better?
Ever since Citi announced on April 16 that South African government bonds would join its World Government Bond Index (WGBI), almost 20 billion rand (over $2.5 billion ) in foreign cash has flooded to the local debt markets in Johannesburg, bringing year-to-date inflows to over 37 billion rand. Last year’s total was 48 billion. Michael Grobler, bond analyst at Johannesburg-based brokerage Afrifocus Securities predicts total 2012 inflows at over 60 billion rand, surpassing the previous 56 billion rand record set in 2o1o:
The assumption..is based on the fact that South Africa will have a much larger and diversified investor base following inclusion in the WGBI expanding beyond the EM debt asset class
Currently South African bonds are restricted to emerging local bond indices. The most-widely used, JPMorgan’s GBI-EM, has less than $200 billion benchmarked to it and South Africa’s weighting is 10 percent. But the WGBI is a different matter altogether — around $2 trillion is estimated to track this index which currently includes just 22 countries, only three of them emerging markets. An expected 0.44 percent weighting for South Africa implies inflows of $5-$9 billion, analysts estimate.
Some of that cash has already come. How much more could roll in this year? Optimists point to Mexico – foreign ownership of the local debt market there rose to 31 percent from 24 percent over 2010, the year the country joined the WGBI, with $11 billion flowing in. But the picture in South Africa is in fact not that rosy. Inflows will undoubtedly pick up, benefiting both bonds and the rand but many reckon positioning in South African bonds is already pretty crowded – about a third of the market is in foreign hands already, analysts at Morgan Stanley reckon. Worse, the country faces a possible credit ratings downgrade this year (all three rating agencies have cut its ratings outlook to negative in recent months).
Kieran Curtis, a fund manager at Aviva Investors upped his holdings of South African local bonds after the WGBI news but is reluctant to go overweight, betting the market will benefit less than Mexico did two years ago. He cites two reasons — first South Africa’s budget deficit has been creeping higher and it follows that debt issuance will too. Second, the external backdrop is less supportive today than two years ago when the Fed was in full money-printing mode:
I wouldnt say I detect a very strong commitment in South Africa to restoring the budget to balance and those debt numbers can rise quickly when you have a 5-6 percent deficit. Also Mexico’s inclusion came at a time when U.S. Treasury yields were falling fairly quickly but now, with Treasury yields rising we may not get the same support for South Africa.
Asian bonds may suffer most if QE on ice
Bonds issued in emerging market currencies have been red-hot favourites with investors this year, garnering returns of 8.3 percent so far in 2012. But for some the happy days are drawing to a close — U.S. Treasury yields are nudging higher as the U.S. recovery gains a foothold and the Fed holds back from more money printing for now at least. That could spell trouble for emerging markets across the board (here’s something I wrote on this subject recently) but, according to JP Morgan, it is Asian bond markets that may bear the brunt.
Their graphic details weekly flows to local bond funds as measured by EPFR Global (in million US$). As on cue, these flows have tended to spike whenever central banks have pumped in cash. (Click the graphic to enlarge.)
Over the past several years, inflows have driven local curves to very flat levels, but current levels of flatness are not sustainable if/when inflows begin to slow, let alone reverse.As there is a clear correlation between the Fed’s “QE periods” and large inflows into Asian markets, we think the next few months will be difficult for Asian bonds markets (JPM writes)
JP Morgan says risks are greatest for Malaysia, Indonesia and Thailand because that’s where foreign ownership ratios are largest – in Indonesia for instance foreigners hold a third of local debt. Deficits in these three countries are also rising meaning debt issuance is rising faster than elsewhere, the bank warned. It advises clients to be underweight Asian local debt (countered by overweights in Latin America and emerging Europe)
Asian currencies face risks too –from China. The yuan is up 30 percent since mid-2005 but ended March with its first quarterly loss since 2009 and many reckon China, fearful of an exports slowdown will not permit any more big rises for now. Asian governments will have to fall into step if they want their own exports to compete. And that, JPM says, is robbing the region’s currencies of a major support anchor.
Emerging market local bond rally has more legs
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:
From an EM perspective there is little reason to fight the rising tide of monetary policy support in the near term. Comparisons to the 2009 global carry trade are unavoidable given the scope of G-4 central bank balance sheet expansion.
So far, around 70 percent of the gains posted by the GBI-EM index have been down to currency appreciation (see here). That could change going forward as some central banks may act to slow FX appreciation. That’s already been happening in Brazil. Gains from the duration trade — derived from interest rate cuts — are also more or less done, analysts reckon, because emerging central banks are more likely from here to keep interest rates on hold than to cut. J.P. Morgan adds:
While we look for approximately 7 percent in additional returns in the GBI-EM for the remainder of the year, the majority of this is due to carry (5 percent) while spiot FX returns should be muted at 1.9 percent and duration returns flat.
What to do with Belize’s superbond
This year’s renewed euphoria over emerging markets has bypassed some places. One such corner is Belize, a country sandwiched between Mexico and Guatemala, which many fear is gearing up for a debt default. There is a chance this will happen as early as next week
Belize is a small country with just 330,000 people but back in 2007, it issued a $550 million bond on international markets. Known locally as a superbond for its large size (relative to the country’s economy), the issue earned Belize a spot on JP Morgan’s EMBI Global index of emerging market bonds.
As this index is used by 80 percent of fund managers who invest in emerging debt, many of them will have allocated some cash to hold the Belize bond in their portfolios. These folk will be waiting anxiously to see if Belize pays a $23 million coupon due on Feb. 20.
Never very liquid, the bond has taken a sharp lurch downwards since Feb.7 when Prime Minister Dean Barrow said in a pre-election speech that he would seek “instructions” from the electorate to “do something about the bond”. That unsurprisingly triggered panic selling and the bond now trades around 40 cents on the dollar, down some 20 cents since the start of February. The yield has risen sharply to 23 percent from 16 percent and and the Belize spread over U.S. Treasuries — the premium that investors demand to hold the bond — has blown out to almost 2000 basis points, higher than any other country in the EMBI Global index. That’s a rise of 400 bps since the day of Barrow’s speech.
Exotix, a frontier market-focused brokerage says:
What happens next? We think the government will pay the forthcoming 20 February coupon but clearly there is a risk that it won’t. But even if it does, that does not remove the uncertainty now hanging over the bond… The government has the money and it might be counterproductive politically to default just before a general election. However we do acknowledge that the bond’s domestic unpopularity and the low price make non-payment an easier option.
Regionally, there are some parallels with Ecuador which in 2008 defaulted on debt the government said had been contracted unlawfully by a previous administration. Investors pointed out at the time that Ecuador’s president Rafael Correa had the cash to pay but did not want to. If Belize misses the Monday coupon, it will not be for want of cash — the central bank has $240 million in its coffers.
Currency rally drives sizzling returns on emerging local debt
Emerging market bonds denominated in local currencies enjoyed a record January last month with JP Morgan’s GBI-EM Global index returning around 8 percent in dollar terms. Year-to-date, returns are over 9.5 percent.
This is mainly down to spectacular gains on emerging currencies such as the Mexican peso and Turkish lira which have surged 7-10 percent against the dollar and euro this year. Analysts say the currency component of this year’s returns has been around 7 percent, meaning any portfolio hedged for currency risk would have garnered returns of just 2.5 percent.
The gains come as good news to investors licking their wounds after the index ended 2011 in negative territory. A mid-year rout on emerging markets pushed up local bond yields, often by hundreds of basis points and sent many currencies to multi-year lows.
Now, promises of more cheap cash from Western central banks has changed the mood, driving currency rallies. Adding to the optimism is the hope of more interest rate cuts in emerging markets, where inflation has peaked and growth is slowing.
Buy more yen… to increase reserve returns
Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.
However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.
JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.
Instead, it says, they should buy more yen.
“Diversification has targeted cyclical assets such as commodity currencies, which impart more leverage than safety to a portfolio. A much higher allocation to structural funding currencies such as the yen is required for reserve managers concerned with volatility and drawdown,” JPM says in a note to clients.
According to the latest reserve data from the IMF, central banks — which control reserves of over $10 trillion worldwide — hold 60 percent in dollars, 27 percent in euros and 4 percent in sterling and yen respectively.
This would have returned 1.5 percent in the past two years and 2.9 percent in the past five years.
Developing vs developed. Ratings convergence goes on
Watchers of ratings agencies might be wondering if a golden period of steady credit upgrades for emerging economies is coming to an end. This week brought a ratings downgrade for Egypt and an outlook cut for Turkey. Hungary is teetering on the brink of having its rating cut to junk. Across the emerging world, countries are struggling with weaker growth, still-high inflation and falling investment. Debt ratios are rising. All this could bode ill for sovereign credit ratings.
But no fear. The so-called ratings convergence between developed and developing economies has some way to go yet. Egypt and Turkey may have received bad news this week but there were ratings upgrades for Kazakhstan and Georgia. Emerging countries are still more likely to be upgraded than downgraded. Debt-ridden rich nations on the other hand face ratings cuts, including possibly the mighty United States. JPMorgan points out that, emerging markets have enjoyed 35 upgrades this year, while developed sovereigns have suffered 32 downgrades and no upgrades. The bank predicts an additional 22 upgrades for the developing world in 2012.
“The convergence trend appears likely to continue, since a total of nine developed market countries remain on negative outlook or review for a possible downgrade,” according to JPMorgan. Emerging economies have received 133 sovereign upgrades since 2008, the bank notes. The last developed country upgrade that still stands? Sweden’s move up to AAA — achieved in 2004.
Emerging bonds say thank you, Ben
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 this 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.
