Warning Signs in Emerging Market Debt

By Paul Amery

Emerging market debt prices have so far proved immune to fears of a global double dip. But is there trouble ahead?

Yesterday’s closing NAV for the iShares JP Morgan $ Emerging Markets Bond Fund [LSE: IEMB], 108.71, was a record high since the ETF was launched in February 2008. On a total return basis, IEMB has appreciated by 79% since its low on 24 October 2008.

Expressed in income terms, IEMB now trades at a yield to maturity of 5.29%, compared with a high of 11.89% recorded 22 months ago.

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When valued in yield spread terms against US Treasury bonds, however, IEMB is still lagging the low reached in late April. In the chart below I show the yield pickup from IEMB over IBTM, the iShares Barclays Capital $ Treasury Bond ETF, which has a similar duration.

On a spread basis, IEMB hit a low over IBTM of under 3% in late April, a level last reached in mid-2008, just before emerging market bond spreads blew out dramatically. Despite the recent run-up in the emerging market bond ETF’s NAV, its spread over IBTM remains stubbornly higher than a quarter ago.

And in this divergence between the low absolute level of emerging market debt yields and subtly widening spreads perhaps lies a reason for caution on the asset class.

The record low interest rates now being paid by a series of emerging market borrowers – such as Brazil, Chile,and the City of Moscow, to give just three examples – is coming at a time when the supply of bonds is also hitting a record.

According to Reuters, emerging market debt issuance in July topped US$35 billion, close to the all-time record US$40 billion sold in April and the US$36 billion sold in May.

Anecdotal evidence suggests that issuers are rushing to lock in current low yields while they can: Bloomberg reports that Brazilian corporate debt issues are set to hit a ten-year record this month, a surprising volume for an assumed holiday month.

Emerging market bonds, like corporate high yield debt in developed markets, have benefited from the record low interest rates in major economies, which have caused a rush for investments offering better rates of income.

As iShares reported earlier today:

Interest in emerging market bonds has been strong over the last six months, with inflows of US$500 million into the iShares JPMorgan $ Emerging Market Bond Fund this year. Corporate and emerging market bonds have offered relatively high yields in a generally low yield environment, and investors have used these sector ETFs to participate from the risk premium over government bonds.

But are investors forgetting the very reason for near-zero interest rates in the US, UK, Eurozone and Japan in the first place, namely the fragility of the global economic outlook?

If the world economy declines again, then the default risk premium on emerging market debt is almost certain to pick up from current lows. Add to that a potential supply/demand imbalance in the primary market for emerging debt issuers, and there appear to be plentiful reasons for investor caution.

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