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Categorized | Capital Markets, Currencies

How longer can the EM bond rally run?

Posted on September 28, 2016


Emerging market bonds are rallying strongly with yield-seeking investors fleeing the ultra-low and negative rates of the developed world.

The twists and turns for EM have been notable throughout the year. The march higher has been powered by 12 straight weeks of inflows into emerging market debt funds, according to data from Bank of America Merrill Lynch and EPFR Global.

    With EM fund inflows running at more than $30bn so far this year, some are wary about how much further the rally can run.

    “How close are we to an inflection point globally such that the strong winds at the back of EM start to swing around and become headwinds?” says Chris Gilfond, an emerging markets origination banker at Citi. “It won’t impact all of EM evenly, but that is going to be a difficult time for our market”.

    Emerging markets have arguably benefited from central bank policy in developed economies driving yields lower.

    “The only countries in the world that are actually normal — normal monetary policy, normal interest rates — are emerging market countries,” says Jan Dehn, an investor at Ashmore, the investment house.

    Hence the close attention being paid to the US dollar and Federal Reserve policy intentions, given the large exposure of EM companies and economies to debt denominated in the reserve currency. Growing talk of fiscal measures in developed economies, as the prolonged era of low interest rates has failed to ignite growth, also looms as a challenge for advocates of EM assets.

    Paul McNamara, investment director at GAM, says: “We are only a run of decent data away from a dollar rally.’’

    And there is no shortage of examples of the twisting run EM debt has been on of late, highlighting the dangers and opportunities in the market.

    This May, when Russia sold its first international bond in three years, delays centring on whether the debt would be eligible for international settlement resulted in the sale of $1.75bn of paper rather than the $3bn originally planned.

    Fast forward to last week and Russia tapped the same bond, raising an additional $1.25bn at a yield of 3.6 per cent, almost a whole percentage point lower than the rate seen in May. That bond currently trades at almost 108 cents on the dollar.

    While Russia is a specific case — the bond was its first since the US and EU imposed sanctions against Moscow linked to the conflict in eastern Ukraine — the rising price reflects a rally in emerging market sovereign bonds that has gathered pace over recent months. The JPMorgan global diversified composite index covering emerging market bonds is up almost 15 per cent this year.

    “In a world of very low rates, emerging markets shines through as a place where you can get some interesting relative value in a world that is increasingly devoid of it,” says Mr Gilfond.

    Many emerging market issuers are willing to meet this growing demand. In the same week that Russia tapped markets, Argentina announced its first euro-denominated bond in more than a decade, following Chile, Colombia and Peru.

    Emerging market sovereigns have issued €28bn of bonds in euros so far in 2016, already matching 2015 and close to the highest annual total this century, according to Dealogic. They are also on course to raise a record amount of debt in capital markets globally.

    Other than internationally marketed bonds, another significant factor in the strength of EM bonds is the strength of local currencies against the dollar.

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    After 2015 was characterised by bouts of extensive weakness and after sharp falls at the beginning of this year, EM currencies have prospered — JPMorgan’s emerging market FX index is up almost 9 per cent for this year.

    EM currencies have been helped by a revival in the price of oil from below $30 a barrel in January and frequent bouts of caution from the US central bank, which has kept the dollar at bay. Brazil’s real is up 23 per cent against the dollar and the South African rand 13 per cent.

    Extremely low yields in Japan and Europe have encouraged investors to look for new opportunities, bolstering EM assets.

    “People do want to take much more risk, more corporate, more high-yield, especially EM,” says Mr McNamara, adding that one of the issues holding back risk-taking was the Fed’s September meeting.

    In fact, the peculiar monetary conditions gripping the global economy could play out well for emerging markets.

    “If you believe there’s going to be a gradual rotation of global capital back to EM, you’re going to see some really interesting almost goldilocks scenarios play out,” says Mr Dehn, pointing to a “disinflationary effect” from capital flows, stronger currencies, cheaper imports and lower prices. “You’re going to see disinflation and higher growth at the same time.”