Why emerging market bonds are not the answer for the yield-starved

The total figure runs into the trillions, but the pool available to western investors is small

by: Jonathan Wheatley

Ten-year dollar-denominated sovereign bonds issued by Brazil pay investors about 4.5 per cent a year © Bloomberg
Starved of returns in their home markets, institutional investors across the developed world have been pouring money into emerging market assets at a rate of more than $20bn a month since the middle of this year — quite a turnround after the outflows that dominated much of the previous 12 months.

An improving outlook for many EM economies is one factor but the big imperative driving the flows comes from the more than $13tn of bonds in developed markets that now charge investors for the privilege of owning them. The perennial hunt for yield has taken on a new urgency. The question is whether EM bonds as an asset class have the capacity to meet the demand.

“People are desperate and frustrated,” says Atanas Bostandjiev, head of Gemcorp Capital, an investment management firm specialising in EM fixed income assets. “They don’t want to commit long term at these [developed market] levels but they have to put their money somewhere.”
EM bonds offer an appealing alternative. Ten-year dollar-denominated sovereign bonds issued by Brazil, for example, a country starting to pull itself out of a deep recession, pay investors about 4.5 per cent a year.

But are there enough such bonds to go round?

Figures compiled by Bank of America Merrill Lynch, based on data from the Bank for International Settlements with additional figures from Bloomberg and national central banks, show the total stock of EM bonds and other tradable debt — meaning it can be bought and sold, on or off an exchange — added up to $18.2tn at the end of 2015.

With issuance of new international bonds by EM sovereigns running at a record high this year, the total is likely to have risen to about $18.5tn today.

While this is dwarfed by the amount of outstanding debt issued by governments and companies in developed markets, it still makes EM debt a substantial asset class, bigger than the roughly $16tn market in US government debt, for example, according to the BIS.

But how much of this debt can be bought by international investors, many of whom operate under rules that restrict the bonds they can buy to issues over a certain size or to those that are listed in market índices?

Low rates tempt governments from Argentina to Saudi Arabia to issue bonds

While most of the $850bn of EM sovereign bonds will be open to them, along with most (though not all) of the nearly $2tn of bonds issued internationally by EM banks and non-financial corporations, only a “tiny, tiny” proportion of the $15.5tn in EM local-currency tradable debt is actually traded by foreign investors, according to Jane Brauer of BAML, responsible for compiling the bank’s data.

The bonds in JPMorgan’s benchmark index of local currency EM government debt, for example, have a total face value of roughly $1.7tn. BAML’s index of local currency EM corporate debt has a total value of just $170bn.

Were yield-starved institutions to make a mass move into EM debt, supply would quickly run dry.

“EM bonds are not the answer,” says Mr Bostandjiev at Gemcorp. “If all the pension funds put 2 or 3 per cent of their assets in EM debt, there would be a massive rally and yield compression.”

If big institutions did make such a move, they would be likely to stop long before they ran out of supply. Mr Bostandjiev, who is currently putting his clients’ money into Brazilian, Argentine, Russian, Kenyan, Nigerian and Angolan debt, among others, says 10-year sovereign bonds from Bulgaria, for example, yielding about 1.8 per cent, already fail to reward investors for the risks they are taking.

“In peripheral Europe, prices are driven by technical reasons, by the huge supply of liquidity from quantitative easing programmes in western Europe,” he says. “They are not driven by fundamentals.”

While he still sees several opportunities in EM debt, prices in parts of the asset class have already been distorted by the expansionary policies of western central banks.

“Central banks have become the markets,” he says. “They are influencing government bonds, corporate bonds, interest rates, even equities. What will they do next — target asset prices? That just causes further distortions and it will end in tears.”

David Hauner, head of EM strategy at BAML, says such distortions risk driving a bubble in EM debt markets as early as next year.

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“Nobody doubts there is a bubble in developed market fixed income due to the demand caused by central banks,” he says. “Why would EMs not go the same way? If you get another six months of EM economies looking in better shape and people falling over each other to buy, there will inevitably be a scarcity of assets, not in the next month but potentially next year.

“The last EM bubble ended badly with the taper tantrum [of 2013],” he adds. “I would argue that we will repeat exactly the same story.”

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