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Mongolia bond sets off EM bond bubble concerns

Mongolia’s debut bond ran into trouble after a spat within the country's coalition government, underscoring politicial risks in the frontier market. The liquidity-fuelled demand for the country's bond brings to the fore the question of whether there is a bubble surfacing in emerging market debt, more generally.

Mongolia’s debut bond issuance was off to a great start on October 29, attracting $15 billion-worth of interest – 10 times more than the $1.5 billion issued – for the 10- and 5-year notes.

Nambar Enkhbayar  
Source: Reuters
The bond was equal to one-fifth of the size of Mongolia's economy, and its demand equated to twice the country's GDP. The deal, the biggest in Asia for more than a decade, is so substantial that the country does not even have net international foreign exchange reserves to cover it. 

Investors were attracted to Mongolia’s robust GDP growth (17.5% in 2011), wealth of natural resources and proximity to Asian heavy weight China. However, after the landmark issue, the government of Mongolia ran in to trouble after spats within the coalition threatened to derail the government, triggering bond yields to soar.

A minority member of Mongolia’s fragile coalition, the Mongolian People's Revolutionary Party (MPRP), last week announced it would quit the country’s ruling coalition in protest of MPRP leader Nambar Enkhbayar’s arrest on charges of corruption. The onset of political instability in Mongolia has brought to the fore questions surrounding emerging market fundamentals and whether there is a bond bubble emerging in the sector.

So far this year, there has been more than $400 billion EM bonds issued, up approximately 60% on last year, way above the 2010 record at $284 billion. November was the second most active month of the year after September for emerging market bond issuance.

Yield-hungry investors' demand for hard-currency denominated emerging market sovereign debt is a well-known phenomenon. And during liquidity-fuelled rallies, investors have been bitten on countless occasions, particularly when the size of the transaction triggers debt sustainability concerns. For example, in October 2008, Seychelles defaulted on its $230 million bond after an economic crash made servicing the transaction unfeasible - since it represented 40% of the island nation's GDP.

Liquidity rally

When the third round of quantitative easing was announced on September 13, there was a massive jump in demand for emerging market debt, says Andre de Silva, deputy head of global fixed income strategy at HSBC in Hong Kong. “In absolute terms, hard currency debt was the biggest beneficiary of liquidity," he says. "But local currency debt saw the sharpest increase in growth as investors sought to lock in currency gains.” At the same time, the allure of low rates, triggered new issuance, from corporates and sovereigns alike. 

“Western central banks are keeping rates at artificially low levels and bank lending has dropped off,” says Mark Whitcroft, director of debt syndicate at Deutsche Bank based in Singapore. "As the rates trend remains low and credit spreads have continued to compress, the international bond market remains a compelling alternative for funding," he says.

While analysts reckon the biggest risk-reward trade-off remains the high-yield sector, and in China, in particular, the sovereign debt market, in general, will remain buttressed by strong growth and consistent demand for an asset class that is still, relative to G7 credit, in short supply. 

Citing elevated demand for emerging market corporate debt, Shamaila Khan, head of emerging markets corporate debt at AllianceBernstein, warns that investors need to wake up to corporate governance concerns, capital structures and valuations.

“Top-down, the market looks well and will continue to look this way,” said Khan. "Bottom-up, there are some concerns and there could be potential for a bond bubble."

De Silva at HSBC, however, argues there is not a bond bubble on the horizon, but “it is possible that in some cases, valuations have been overstretched. There could be bubbles within certain asset classes, but it is too early to tell.”

He adds: “With the onset of Basel III, banks' liquidity might dry up and there could be constraints in the secondary market, and there could be problems with the high yield [sector].”

Khan agrees that high yield could prove to be a tricky sector, especially in China. “The market is fairly young, and there has been strong demand from private banks in Asia and beyond [for Chinese high yield]," she said. "But there is structural subordination in the bonds the company fundamentals don’t reflect bond valuation.”

Nevertheless, investors agree there is definitely value in the asset class, but some less-experienced investors are uneducated about the fundamentals of the bonds and do not discriminate between credits.

“A few negative events will trigger investor caution when it comes to emerging market debt but we don’t really know when people will start focusing more on fundamentals. Overall, however, we do see a positive scenario for emerging market corporates,” said Khan. 

Indeed, the aftermarket fallout from Mongolia’s issue did little to deter investors in Morocco’s dollar-denominated bond. The country raised $1.5 billion in a dual-tranche highlighting investors hunger for emerging market debt.

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