Emerging debt a scant refuge from credit storm

Credit rating downgrades in the United States and Europe may have thrown into sharp relief the improving quality of emerging debt but as a shelter from the credit storm now buffeting global markets, the asset class could prove flimsy.

Going purely by macroeconomic fundamentals, the case for emerging country bonds is probably stronger than at any point of their history. With over 80 percent of the world’s foreign exchange reserves, emerging economies are a welcome respite for investors increasingly fretful about the solvency of sovereign creditors in the industrialised West.

“The U.S. downgrade is the ultimate symptom of the convergence of creditworthiness between emerging and developed markets; it suggests the old way of thinking about emerging market risk no longer applies,” writes HSBC’s Global Head of Emerging Market Research Pablo Goldberg.

But notwithstanding a broad portfolio shift in their favour, emerging debt markets remain hobbled by curbs on foreign capital. What looks to be a re-pricing of risk/return also looks less attractive taking inflation into account.

“People are convinced that emerging debt is a long-term bet because of the favourable credit metrics … But the emerging markets story is also one about growth and that’s something we are all worried about now,” said Pierre-Yves Bareau, head of global emerging debt at JPMorgan Asset Management.

In terms of relative creditworthiness, emerging economies are fast catching up.

According to Morgan Stanley, emerging sovereigns now have an aggregate investment grade score of ‘BBB-‘, with countries such as Brazil, Indonesia and Peru poised for upgrades.

Of the emerging sovereigns rated by Standard & Poor’s, 15 percent have a positive ratings outlook — as many as are on a negative outlook footing. Compare that to the developed economies rated by S&P: nearly a third have been placed on a negative ratings outlook.

This ratings trajectory has been imperfectly reflected in market year-to-date performance.

The JPMorgan EMBI+ Index — the emerging sovereign debt benchmark — returned a modest 6 percent so far this year, outpaced slightly by the seven-percent return in dollar terms by its local-currency counterpart.

An investor sticking to U.S. 10-year Treasuries, however, would have enjoyed a nearly 12 percent return.

“The market doesn’t necessarily assess risk as credit rating agencies do,” said Regis Chatellier, senior emerging markets strategist at Morgan Stanley.

RISK RETHINK

In fact, many holders of local bonds have taken a hit on the exchange-rate front in recent weeks since central banks from Istanbul to Seoul started to slow the pace of monetary tightening to cope with weaker global demand.

Though emerging currencies are currently on the back foot, their long-term appreciation is widely seen as an inevitability. Investors are thus willing to weather currency weakness even to the point of tolerating bond returns that are below inflation.

UBS strategist Manik Narain notes that real yields on local bonds have shrunk in emerging markets even to the point of turning negative in some, meaning income returns are being eroded by inflation.

“Typically investors have demanded positive real yields as part of emerging markets’ risk premium. But falling real yields are an indication of how emerging markets are getting re-priced. Investors are more willing to hold emerging debt as part of a diversification play,” he said.

Current valuations also reflect a touch of investor complacency about inflation, Narain warned.

Global food prices remain near three-year highs, posing a significant risk to emerging economies where consumers spend a larger portion of their income on staples.

For now, the easing of early year fears over inflation has helped lure investors back to local-currency emerging debt, helping the asset class to weather recent volatility.

Though emerging hard-currency bond funds saw their worst week this year, EPFR data shows emerging local debt funds among the few fund groups to absorb new money in the week ending Aug 10, when market strains over the sustainability of U.S. and euro zone sovereign debt were most acute.

The resilience of emerging local debt is all the more impressive considering the record $10.4 billion (6.3 billion pounds) that fled bond funds overall during the week.

But the size of the emerging debt market is likely to stymie any massive shifts away from U.S. Treasuries and other bonds issued by major developed economies.

Even combining the $1.5 trillion in external debt with the $11 trillion in local-currency bonds issued by sovereign and corporate borrowers, emerging markets still account for a mere 12 percent of the total global fixed-income volumes, notes David Spegel, ING’s global head of emerging markets strategy.

“Even if you add emerging bonds and equities, you’re still only 16 percent of the global securities universe … This means a small window for the entry and exit of fund flows,” said Spegel.

The biggest emerging economies — Brazil, China, India and Russia — retain restrictions on foreign participation in their domestic bond markets.

While the asset class will undoubtedly grow, the euro zone debt crisis could put some emerging markets off from opening their domestic capital markets too quickly with Greece and Spain offering high-profile illustrations of countries hurt by large levels of foreign ownership of their bonds.

“In some cases, we’re seeing movement in the opposite direction with governments imposing controls on the inflow of capital,” Spegel said.