Emerging market bonds: bubble trouble

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International money is flying into emerging market sovereign bond markets with frontier credits, such as Zambia, Mongolia and Bolivia, now boasting low yields. The jury is out on whether there is a bubble brewing in developing bond markets in hard currency.

At the end of November, Mongolia, which has seen five IMF rescue programmes in the past 22 years, sold $1.5 billion in debt. The sale was equal to almost 20% of the country’s economy – equivalent to the US issuing $2.5 trillion.

The five-year notes yielded 4.125% and the 10-year 5.125%, and the country saw total demand worth more than its GDP. That deal followed a $500 million 10-year deal from Bolivia, which in October priced at par with a 4.875% coupon – just US treasuries plus 306 basis points. Demand for the deal reached $4.25 billion.

Edwin Gutierrez, portfolio manager at Aberdeen Asset Management, thinks the latter, in particular, shows the heat in the international emerging market (EM) bond market. “[Bolivia] is a far more egregious example – at least Mongolia had some outstanding bonds with which you could benchmark, whereas Bolivia has a history of nationalization.”

Stuart Culverhouse, chief economist at Exotix, says the huge demand for EM sovereign paper is now the norm: “It was a similar thing with Zambia in September, which had orders of $11 billion and the cost of financing [of these EM economies] is 4%, 5% or maybe 6%. You might think the cost of financing for the frontier economies would be a lot higher but clearly the push and pull factors at play are [having a big impact].”

Traditional EM credits, such as Brazil, Mexico and Turkey, have substantially reduced supply, as they have switched their funding strategies to domestic capital markets in local currency format, just as demand for emerging market sovereign deals, denominated in hard currency, has jumped, particularly among pension funds and insurance companies in the west.

New herds

Core EM investors have been joined by an increasing number of cross-over investors, attracted to the asset class by yields, which are considerably higher than those on offer from developed market credits. The relative strengthening of these economies’ fundamentals is driving to this re-allocation effect.

Gutierrez says despite the new issuance pricing pressure that the new investors into the asset class create, there are still opportunities for the established players to profit. He points to the 8% fall in the price of Mongolia’s bonds when investors were spooked when one of the coalition government’s minority parties threatened to leave.

He says the underwriters’ decision to allocate much of the primary issue to private banking clients, who he argues are inexperienced in the sector, proved costly.

“That had more to do with poor placement than anything to do with the underlying fundamentals,” says Gutierrez. “There was just too much private banking money from Asia who had no clue about the fundamentals and when there was a negative news story it started to sell off. It just shows you the ignorance of the investor base that it was placed with and they just had to wait for the professional hands [to come in] and support the deal.”

 
Hoguet of State Street 
New issuance demand and pricing is being further accentuated by the lack of liquidity in the secondary market. New banking regulatory requirements – such as Dodd-Frank and Basel III – mean fewer banks are acting as market-makers, with bond managers, subsequently, unwilling to put substantial new money to work outside primary deals, fearing secondary market illiquidity will cause them to move markets.

That has led to a jump in primary market demand seen in recent deals, exacerbated by the inevitable problem of padded orders.

“The success of these [frontier sovereign issues] is indicative of a wall of liquidity,” says George Hoguet, managing director at State Street Global Advisors. “Right now, you have a situation where the pull factors are very strong. Central banks have removed tail risks, so in an environment of reduced volatility – the VIX has continued to fall – that is obviously symptomatic of higher risk appetite, so the question is how long this carry trade will continue to last?”

Lack of sovereign supply has seen EM corporates take up the mantle of issuance. Record corporate volumes in 2012 could well be matched in 2013 and investors are diversifying into local currency domestic transactions, as well as corporate and quasi-sovereign transactions. For example, Pemex trades about 90bp wide of Mexico’s sovereign debt, despite having a stronger credit rating.

“EM corporates seem a little stretched compared with sovereigns, particularly in Asia where demand has been significant,” says Cathy Elmore, portfolio manager at Standish, the fixed-income specialist division of BNY Mellon. “In November, this part of the asset class saw some indigestion, given the significant amount of issuance that was coming out compared with the small size of the market.”

 
Culverhouse of Exotix 
Investors do not generally expect a re-run of the 1993/1994 sell-off when interest rates in developed markets began to rise, but Hoguet says: “There will come a point when the bond market will sell off and historically financial crises have come when rates are rising – the asset class had probably got more room to go but within individual credits there are certainly some markets that are mispriced.”

However, even if some – or all – of EM bonds are mispriced, Exotix’s Culverhouse argues there is little alternative than to keep investing.

“If you think there is bubble in EM, you still have the problem of where else are you going to put [your money],” he says. “You are not necessarily going to put it in DM bonds, some Treasury bills are negative in real terms, some people are avoiding stock markets and property is overheated in some markets. Commodities have been up and down. “

“So even if there is a bubble, is it relative to an alternative asset class or are [those alternatives] affected by the same bubble?”
 
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