Emerging Bonds Show Ratings Don’t Matter

For the first time in five years, emerging-market debt is breaking its link with riskier assets and trading in sync with securities investors deem the safest.

Gains in local-currency debt of developing nations sent yields on the benchmark index to a nine-month low even as bonds of similarly-rated U.S. companies fell this month and the value of global stocks tumbled by $6.8 trillion on concern the economy may stall. Yields have diverged from the VIX index, known as the fear gauge for the Standard & Poor’s 500 Index, for the first time since May 2006 and are moving in line with Treasuries by the most in five years, according to data compiled by Bloomberg.

“If we get a period of lower global growth, emerging- market local bond yields will continue to rally,” Michael Gomez, the Munich-based co-head of emerging markets at Pacific Investment Management Co., which oversees $1.3 trillion including the world’s biggest bond fund, said in an Aug. 17 interview on Bloomberg Radio. “That’s a good place to be.”

While developing-nation bonds sank with stocks and junk- rated company debt as investors retreated from riskier assets in October 2008 and May 2010, fund managers are now treating sovereign debt of Indonesia and Turkey as havens, similar to U.S. and German securities.

This month’s 2.2 percent gain in the JPMorgan GBI-EM Global Diversified Index of local-currency emerging-market bonds compares with a 3.4 percent rally in Bank of America Corp.’s gauge of Treasuries and a 4.3 percent drop in Barclays Plc’s index of U.S. high-yield notes.
Ratings Logic

The advance in emerging-market debt is another sign of the countries’ growing clout in world financial markets and shows investors are looking past the analysis of ratings companies such as Standard & Poor’s, which ranks Turkey and Indonesia BB+, one level below investment grade.

Turkish local-currency bonds gained 2.6 percent this month, while Indonesian debt increased 1.9 percent and Brazilian bonds, rated BBB+ by S&P, the third-lowest investment grade, gained 3.4 percent, according to JPMorgan Chase & Co. indexes.

“Ratings are not logical,” said Jeremy Brewin, who helps manage about $3.6 billion in emerging-market debt at Aviva Investors in London. Both Indonesia and Turkey deserve investment-grade debt ratings as long as the U.S. and some European nations grow faster than recession levels, he said.
Investor Confidence

The governments of Indonesia and Turkey, which can impose taxes or print money to repay their debts, are rated at BB+ for local-currency bonds, the same level by S&P as Birmingham, Alabama-based lender Regions Financial Corp. The bank’s 5.75 percent notes due June 2015 have retreated 6.1 percent this month while the shares tumbled 37 percent on concern earnings will drop as the economy slows. Turkey has a BB rating from S&P on its foreign-currency debt.

Treasuries have rallied 2.3 percent since S&P downgraded the U.S. to AA+ from AAA on Aug. 5. The ratings company, along with Moody’s Investors Service and Fitch Ratings — which both affirmed their top rankings on the U.S. this month — engaged in a “race to the bottom” to assign top grades to mortgage-backed securities at the request of the banks that paid them in 2006 and 2007, helping to cause the global financial crisis, according to a report released by a Senate panel in April.

The sovereign borrowers viewed by investors as most creditworthy are rallying this month after worse-than-estimated U.S. economic data, the unprecedented downgrade of America’s top debt rating and signs that Europe’s most-indebted countries may struggle to repay obligations shook investor confidence.
Lower Debt Burden

Developing nations have cut government debt to 34 percent of gross domestic product from 36 percent in 2009 and 49 percent at the start of the decade, according to the International Monetary Fund. Gross debt in advanced countries has climbed to 103 percent of GDP from 93 percent two years ago and 73 percent in 2000, according to the Washington-based fund. Emerging economies will expand 6.6 percent this year, compared with 2.2 percent in developed nations, IMF forecasts show.

The developing world has learned from past crises “to tremendously improve their balance sheets,” said Gomez, whose $9.5 billion Pimco Emerging Local Bond Fund (PELBX) beat 86 percent of its peers this year, data compiled by Bloomberg show. The debt of Brazil, Mexico and South Africa is “attractive,” he said.

The 120-day correlation between yields on the JPMorgan GBI- EM index and the VIX, as the Chicago Board Options Exchange Volatility Index is known, dropped to minus 0.1 last week, from 0.5 in May 2010, when a divided response by European leaders on how to solve the debt crisis spurred speculation that Greece and Portugal may default, data compiled by Bloomberg show.
‘Lowest Correlation’

The correlation between the GBI-EM index and 10-year Treasuries has climbed to 0.3 from minus 0.2 in May 2010, the data show. A correlation of 1 indicates they move in lockstep, while a value of zero shows there’s no link and a reading of minus 1 shows they move in opposite directions.

“Local-currency debt generally speaking has got the lowest correlation with risk,” said Natalia Gurushina, the New York- based director of emerging-market strategy at Roubini Global Economics, the consulting firm founded by New York University professor Nouriel Roubini.

While emerging-market bonds are rallying, the gains haven’t matched those of Treasuries and German bunds. The yield on the JPMorgan GBI-EM index dropped to 6.37 percent last week, the lowest level since November 2010, from 6.76 percent at the end of July. The rate on U.S. 10-year notes has declined to 2.12 percent from 2.80 percent on July 29, while the yield on bunds sank to 2.15 percent from 2.54 percent.
Weaker Currencies

The extra yield on emerging-market dollar bonds over Treasuries increased 66 basis points, or 0.66 percentage point, this month to 367, compared with a weekly average of 408 during the past decade, according to JPMorgan’s EMBI Global Index.

For U.S.-based investors, advances in emerging-market debt were eroded as currencies weakened against the dollar. Brazil’s real fell 3.1 percent this month, while the Russian ruble depreciated 5.2 percent and Poland’s zloty slid 4.2 percent. The rand lost 6.9 percent and India’s rupee fell 3.3 percent.

Brazil’s benchmark Bovespa stock index tumbled 11 percent during the period. Russia’s Micex sank 15 percent and India’s Bombay Stock Exchange Sensitive Index dropped 10 percent. The MSCI Emerging Markets Index lost 15 percent.

“We are still in a world where if things go sour everybody goes and buys bunds and Treasuries,” Luis Costa, an emerging- market strategist at Citigroup Inc. in London, said by phone on Aug. 16. “You don’t go ‘Oh my God, the world is coming to an end, let me buy Polish bonds.’”
Biggest Reserves

When global credit markets froze in 2008, yields on the GBI-EM index rose to a record 9.73 percent, mirroring the VIX’s surge to an all-time high of 81. Brazil has experienced boom- and-bust cycles of inflation, currency devaluations and interest-rate swings since the end of military government in 1985. Russia defaulted on $40 billion of ruble debt. Asian nations such as Indonesia suffered currency crises in the 1990s.

The three countries have spent the past decade building up foreign-exchange reserves, with combined holdings of $932 billion, in part to prevent larger swings in their currencies. China has $3.2 trillion of reserves, the world’s top holdings.

Investors added money to emerging-market local currency bond funds during the past two weeks even as they exited positions in global high-yield debt, according to data compiled by Cambridge, Massachusetts-based research firm EPFR Global. The emerging debt funds lured $381 million in the two weeks ended Aug. 17, compared with $8.9 billion of outflows from global high-yield funds, EPFR said.
Rates Outlook

“More and more asset allocators are deciding to put that in emerging markets as a safe haven bet,” Edwin Gutierrez, who helps manage about $7 billion in emerging-market debt at Aberdeen Asset Management in London, said in an Aug. 19 phone interview.

Falling expectations for global economic growth and inflation are boosting the appeal of fixed-income investments, said Murat Toprak, the head of foreign exchange strategy for Europe, the Middle East and Africa at HSBC Holdings Plc in London. Morgan Stanley cut its forecast for global expansion this year on Aug. 18 to 3.9 percent from 4.2 percent. The S&P GSCI Spot Index of commodities has retreated 16 percent from this year’s high in April.
Dim Sum Debt

Yields on India’s benchmark 7.8 percent sovereign notes due in April 2021 have dropped 19 basis points this month to 8.27 percent. Borrowing costs will probably fall to 8 percent by year-end, according to Puneet Pal, a fund manager at UTI Asset Management Co. in Mumbai. India’s index of wholesale prices declined to 9.22 percent in July from 9.74 percent in April.

Yields on Brazilian benchmark fixed-rate bonds due in 2021 fell 65 basis points this month to 12.21 percent, according to Bloomberg data. The yield difference between inflation-linked bonds and interest-rate futures, a gauge of investors’ expectations for annual inflation through 2013, has dropped to 544 basis points from 590 at the start of the month.

In China, the yield on yuan-denominated dim sum bonds sold in Hong Kong has dropped by as much as 40 basis points since November. The Ministry of Finance sold three-year notes at a 0.6 percent yield on Aug. 17 as part of a 20 billion yuan ($3.1 billion) offering. Debt of the same maturity was priced to yield 1 percent in November.

“In lots of countries where we had rate hike expectations we have seen a de-pricing of those expectations and in several markets we have even seen a shift from rate hikes to cuts,” HSBC’s Toprak said in an Aug. 19 phone interview.
Pension Funds

Longer-term gains in emerging-market debt may be fueled by increasing demand from pension funds and other large institutional investors in the developed world, according to Aberdeen’s Gutierrez.

Pension funds in Organization for Economic Cooperation and Development countries have “close to zero” allocations to emerging-market fixed-income securities, JPMorgan said in a November research note. Local investors hold as much as 85 percent of the debt, according to the report.

“Allocations still are very low compared to where they should be,” Gutierrez said. “The amount of potential demand structurally for the asset class remains very high.”