IMF World Bank 2006: A bad cas
In what seems like a bad case of deja vu, EM investors are once again hunting for yield among lower-grade corporates and local markets, as external debt re-approaches historic tights. But rich valuations are worrying some participants who feel the market is not pricing in unexpected bad news and could be setting itself up for another fall. Paul Kilby reports.
There is no value in EM external debt, with spreads back near the all-time tights of March, said Julian Jacobson, portfolio manager in charge of fixed income at Fabien Pictet & Partners (FPP), an EM hedge fund. "The combination of low US Treasury rates and low spreads seems pretty dangerous to me."
Similar complaints were heard earlier in the year, when EM spreads hit historical lows and investors moved down the credit spectrum to pick up yield. It was hoped that the sell-off in May and June, albeit brief, would remedy this and help the market properly price in risk.
However, according to JPMorgan, the minimum or 'rock bottom' spreads required to compensate crossover and dedicated investors are still wider than the EMBI Global (EMBIG), indicating that positives such as upcoming upgrades are already priced in and that holders are not being compensated for credit risks. Indeed, this has been the case for crossover accounts since January, and for dedicated investors since June 2005. (See Chart.)
Still, the Federal Reserve's rate pause on August 8 and the emergence of benign inflation figures that same month was enough to tighten spreads further and put to bed, at least temporarily, the US rate concerns that had been hanging over the market throughout brief sell-off.
Such optimism helped the EMBIG snap back to 182bp during the third week of August, only 8bp wide of all-time tights seen on May 1 just before the most recent rout.
Outflows also started to reverse. For the week ending August 16, EM debt funds saw the third straight week of net inflows, with about US$552m running back during that period and US$2.99bn this year, according to EmergingPortfolio.com Fund Research (EPFR).
This marked a turnaround of the May-June retreat, when, according to JPMorgan, cumulative retail outflows reached about US$2.29bn. Strategic inflows also jumped in July to US$875m after dropping during the previous two months, JPM said. It predicts strategic inflows of US$20bn for the full year against US$13bn so far.
Still, the rapid reversal in sentiment, despite lingering doubts about global growth and rich valuations, has raised questions about the sustainability of the rally.
"There isn't any question that over the next few month if flows into EM continue to recover, in time there will be enough critical mass in place to warrant another pull back," said Christian Stracke, head of EM research at CreditSights, an independent research boutique based in New York. "... If investors pile into EM like they did earlier irregardless of risk, they will have to pay for it once again."
However, the growing maturity of the EM external debt market and its broadening investor base probably means that investors' can no longer rely on it for the succulent returns it has served up over the last few years.
Investors' recent reluctance to give up high coupon bonds in exchange for more liquid Brazil bonds is only one example of the changing dynamics of the market and the value put on any paper that can offer decent returns.
The diminishing importance of the IMF is also reflective of investors' confidence in EM governments' ability to withstand downturns, given the significant reduction in vulnerable US dollar debt and the stock piles of hard currency reserves that sovereigns have accumulated over the last few years.
"Nobody cares about IMF programmes in this complacent environment," said FPP Jacobson.
If high returns are what investors want, they will be forced to slide down the credit spectrum or increase exposure to the increasingly dominant, but relatively untested, local markets.
No more home runs
"There are no more home runs left in the EM debt markets," said Bob Kowit, senior portfolio manager at Federated Investors, which manages about US$600m in EM debt. "...Investors must be educated to the fact that EM debt will not produce the double digit returns of the last five years."
With external debt hitting new highs, anecdotal evidence suggests that investors are trickling back into local markets seeking pickup. According to JPMorgan, investors' domestic exposure in Latin America and Asia began to increase again in July, though it continues to decline in CEEMEA, where the reduction in risk was heaviest.
Cathy Hepworth, principal and EM sovereign strategist at Prudential, is one such investor. She has inched up her exposure in local markets by 3% after reducing it by 5% earlier this year.
"We like the opportunities in local markets not only from a carry or yield compression perspective, but the appreciating tendencies of some currencies," Hepworth said.
However, caution prevails in light of the earlier rout. Hepworth is monitoring flows carefully and is more sensitive to hedging in this market. "We and all our buyside brethren had become a little bit too complacent about our risk return expectations in the local markets," she says. "We are more realistic now after seeing how volatile some of these instruments can be."
Kowit remains vigilant and warns that now is not the time to move down the credit and liquidity scale. But he feels relatively safe in local markets like Mexico, where the downside is protected by a strong local bid among pension funds. This is not necessarily the case in Russia and China where foreigners are the principal players, Kowit said.
"A lot of people are being tempted once again to get into the area of EM corporates and local currencies," said Kowit. "It is a different game [and] we are still very cautious there."
Currencies close to fair value
Some investors are taking comfort in the fact that EM currencies are closer to fair value than they were in May and that leverage is lighter. It is hoped that this will result in less violent downturns if the mood should suddenly turns nasty.
"This time around the trades are not as crowded as in May," said Boris Segura, senior EM economist at Standish Mellon Asset Management, which has about 12% of its US$1.4bn EM portfolio in local markets.
"The Fed is on hold for a few more months, and assuming that growth doesn't decelerate fast enough, that environment is supportive of the asset class, but valuations are not. I am agnostic: not a bear, but not a bull," he added.
For now, strong technicals continue to support external debt against bad news elsewhere. Supply has been relatively low, sovereigns are buying back debt and cash positions are increasing.
Despite May and June outflows, EM investors are sitting on more than US$15bn in additional cash thanks to coupon payments, amortisations and bond buybacks that have built up over the past three months, said David Spegel, global head of EM strategy at ING.
"How long they can keep that on the sidelines is questionable," he said. "That is one reason why [EM external debt] has outperformed on the downside and has recovered so rapidly."
Meanwhile, corporate borrowers are preparing to strike while the iron is hot, with a string of new issuance expected in September and beyond.
"The primary [market] has been shut down all summer and many of those issuers will be high beta lower credit issuers in the EM corporate spectrum [that] will get snapped up by investors who have no where else to put their cash," says Stracke.
Corporates is another sector where investors are searching for value. Prudential has about 15% of its US$6.5bn EM debt portfolio in coporates, including quasi-sovereigns such as Pemex, Gazprom and Napacor that give extra yield for what it considers to be sovereign risk.
It has also invested in Double A and Single B rated Asian corproates like Hanaro Telecom in South Korea, Xinao Gas in China and Gujah Tunggal in Indonesia. "We have recently been successful in selling a lot of ... Asian corporates before they traded down," Hepworth said.
Distressed debt or stressed corporates are also appealing to some investors. Latin American hedge fund Copernico Capital Partners, which has about US$300m invested in the region, holds the 11.375% 2007 and 10.75% 2013 bonds of troubled Mexican glassmaker Vitro. "We think the refinancing risk has been reduced significantly and we have done our homework," said Ricardo Maxit, the fund's chief investment officer.
Copernico is also playing it safe by buying short-dated but high coupon paper issued by companies with sufficient cashflows. These include the 10.5% 2007 notes of Mexican logistic and transport company TMM and Banco de Galicia's 2010 RFN. "We focus on short-dated debt where we know the cashflow is strong enough," said Maxit. "We think it will be a good way to withstand volatility."
One of the few sectors where FPP's Jacobson spies value is the Asian high-yield market, where the shock of Ocean Grand's default in China depressed an already soft market. "But you have to do you credit work, because I don't know when the market will bail you out," he said.
Meanwhile, doubts still exist about the Fed's intentions, its ability to bring the US economy for soft landing, and the longer-term global growth prospects. All of these factors could have a negative impact on EM.
But for now EM external debt is still well supported by the litany of positives that market participants have been citing for quite some time now. These include strong fundamentals, sensible fiscal and monetary policies, improved debt metrics and more upgrades on the horizon.