Fears grow over EM sovereign bond bubble

May 23, 2013 9:18 am

Fears grow over EM sovereign bond bubble

By Robin Wigglesworth

As far as financial follies go, tulip mania takes some beating. But future economic historians may look back at the time when investors financed a convention centre in Rwanda as the moment that the rush into emerging market bonds became frothy.

Despite a large chunk of Rwanda’s budget coming from overseas aid – some of which was withheld last year after it was accused of backing rebels in neighbouring Democratic Republic of Congo – investors rushed to get a slice of the country’sinaugural $400m bond last month. The proceeds are largely to be used to pay for a new conference centre in Kigali, the central African country’s capital.US Federal Reserve chairman Ben Bernanke recently warned that he was looking for signs that low interest rates were encouraging “excessive risk-taking”. The most glaring example of bubble-like tendencies is arguably to be found in emerging market bonds, where almost every new offering is met by insatiable demand.

Even investment bankers that orchestrate these bond sales are becoming concerned that the market is overly frothy as cash-rich fund managers seek out any securities that still offer some yield – almost irrespective of the risks.

“I hate to say this, but in five years’ time a lot of this will get hammered,” concedes one. Another senior banker who considered pitching for Rwanda’s bond mandate says he decided against it because “we couldn’t look investors in the eyes and tell them it’s a good deal”.

The demand is partly driven by genuine and significant improvements in the fundamentals in the developing world. Many countries are now investment grade, and enjoy state finances and economies stronger than many rich countries.

But aggressive monetary easing by western central banks has given this rally steroids through programmes that both fill the coffers of investors and beat down yields in traditional markets. That has spurred investors to scour the world for higher returns.

The bond yields of “mainstream” emerging economies such as Mexico, Brazil, Russia and Turkey have tumbled in recent years and are now not far above those of the “haven” bonds of the west.

Bank of America Merrill Lynch points out that $19.4tn of government bonds, almost half the entire global market, is now trading at yields below 1 per cent. That has in turn pushed investors into increasingly obscure corners of the financial system, and encouraged countries such as Honduras and Mongolia to the markets for the first time.

Concerns over a potential bubble are centred mostly on the so-called “hard currency” international bond market, where the securities are primarily denominated in US dollars.

Bonds issued in a foreign currency are protected from the elevated inflation and volatile currencies that frequently plague emerging markets. Local bond yields have also slumped to record lows in many countries, but the dollar borrowing costs are exceptionally subdued.

You can’t buy indiscriminately, but on the whole I’d say risk is still being priced appropriately

– Arvind Rajan, head of international fixed income, Prudential US

There are two main risks for hard currency bonds: that global interest rates rise and erode the value of lower-yielding debt, and that some countries prove unable to repay creditors when the bonds come due.

The first risk reared its head at the start of the year, when US Treasury yields – the pricing benchmark for dollar-denominated bonds – started to climb. As a result, hard currency emerging market bonds suffered their worst quarterly performance since late 2008 in the first three months of this year.

But the Bank of Japan’s unveiling of an aggressive quantitative easing programme in March gave the stalled rally renewed vim. Although rising rates have continued to cause some pain, many investors and analysts predict that the BoJ’s bond buying will compel Japanese institutional investors to join the international search for yield.

Also, many fund managers say that while some signs of froth are clearly apparent, they argue that the rally in emerging market debt is still amply justified by the strong improvements in creditworthiness.

“You can’t buy indiscriminately, but on the whole I’d say risk is still being priced appropriately,” says Arvind Rajan, head of international fixed income at Prudential in the US. “Rates rising would be a concern, but I’m not too worried over default risk, barring a major global tail risk.”

Higher Treasury yields have been a headwind, but on average emerging market bonds still offer a spread, or buffer, of 271 basis points over the benchmark US government bonds, compared with a low of 151bp before the financial crisis. Many investors feel that the spread should come down.

Even sceptics concede that the emerging market bond market will continue to rally as long as central banks such as the Fed keep their feet firmly on the monetary easing pedal.

After all, pension funds and insurers are becoming increasingly infatuated with the asset class, and give fund managers money to invest, not to sit on the sidelines.

“We are worried about some of these countries, but current momentum supports buying their bonds,” says Gregor MacIntosh, head of sovereign debt at Lombard Odier Asset Management. “We’ll just have to be nimble when things turn.”