Emerging-markets bonds

As investors shun higher yields for the security of major-markets bonds, such as U.S. treasuries and German bunds, emerging-markets bonds are being sold off. That’s because developing countries’ debt is probably going to be harder to repay in the slowing global economy.

The need to repay debt in major markets’ currencies, such as U.S. dollars (US$), will make debt repayment for developing countries, which often are commodities exporters, even harder. No wonder investors are heading for the exits.

For financial advisors, the shift reflects a groundswell in risk management. There is a lot of emerging markets’ debt to repay. New issuance of sovereign debt among these countries doubled in the first half of 2015 to US$210 billion from US$121 billion in 2010, according to the International Monetary Fund. That bump in issuance set the stage for the current sell-off, magnified by declines of emerging markets’ currencies.

The Brazilian real tumbled by 25% in the first 10 months of 2015; the Turkish lira and the Colombian peso both dropped by 20% in the same period. Those plunges made investors in the corporate bonds of emerging markets demand an extra 3.8% yield over U.S. Treasury bond rates. However, that extra yield is not as high as the 9.9% premium that emerging-markets bonds fetched in 2008 at the height of the global debt crisis.

Flight from emerging markets shows up in investment flows. Capital Economics Ltd., a consultancy based in London, U.K., says that more than US$260 billion flowed out of emerging markets in the third quarter of 2015. The result has been collapsing prices in emerging-markets debt priced in US$ and, of course, rising yields.

An example: on Oct. 30, Indonesia’s 10-year government bond yield on debt repaid in US$ increased to 8.80% from 8.71% the previous day.

Other developing markets’ yields are soaring. Brazil’s 10-year US$-denominated government bonds offered 15.89% in mid-October, while India’s 10-year government bonds paid 7.64% in US$. Turkish 10-year government bonds priced in US$ paid 9.54% in mid-October.

In the midst of slowing world demand for loanable funds – the core determinant of interest rates – U.S. bellwether 10-year treasuries that pay 2.34% are appealing. So are 10-year Government of Canada bonds, which pay 1.73%.

But the caution flags are out. Higher yields reflect higher risk, after all. The question is whether all the risks now are fairly priced.

Countries risk trouble when they issue debt in a currency that is not their own, says Chris Kresic, partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto.

Rising U.S. interest rates and the resulting increase in the exchange value of the US$ will make servicing outstanding US$- and other major currency-denominated debt harder for developing countries. Says Kresic: “It’s a virtuous circle when the US$ is falling and a vicious circle when the US$ is rising.”

Emerging-markets US$- or euro-pay bonds are not the only ones in trouble. Investors with emerging-markets bonds repaid in the local currency have to carry foreign-exchange risks related to those currencies. From Colombia’s peso to Turkey’s lira, many emerging markets’ currencies have fallen to post-Second World War lows against the US$.

For bonds repaid in US$ – the largest block of outstanding emerging-market debt that is not repaid in local currency – issuers have had to reach deep into their pockets to pay interest. As a result, bond investors may worry that issuers will run out of dollars and default on their debt.

There is also a problem of debt levels in emerging markets. The Hongkong and Shanghai Banking Corp.’s foreign debt research department in London, U.K., produced a research report in October that shows that companies based in emerging markets have an average debt level of 90% of their respective nations’ gross domestic products.

Overall, emerging-market corporate debt denominated in US$ has risen from US$100 billion in 2009 to US$900 billion in 2015, according to an October survey by SG Economics, a London, U.K., unit of Paris-based Société Générale SA.

The combination of foreign-exchange risk and high underlying debt levels are pushing investors to head for major-market fixed-income investments, pending the U.S. Federal Reserve Board’s widely anticipated decision to start raising rates in December.

Looking ahead, if the Fed raises interest rates as expected, then there will be a rush to buy US$ assets and movement out of emerging markets and other debt, says Jack Ablin, executive vice president and chief investment officer at BMO Harris Bank N.A. in Chicago. Most sovereign emerging-markets debt has been issued in US$ since the Asian contagion in 1997 and 1998, he notes. Corporate issuers also have tapped the US$ global pool.

Notes Ablin: “I think that [bond investor] anxiety exceeds the probability of defaults, but price reflects perceived risk.”

The big question: will current valuations of emerging-markets debt hold or drop further?

“High yields already reflect bargain-basement pricing, yet the downward trend of bond prices is continuing,” Kresic says. “Emerging-market bond valuations are already cheap in relation to G7 bonds, and the rising U.S. dollar will put pressure on those bond prices, forcing yields higher. But 80% of the revaluation is already priced in.

“The average spread of emerging-markets bonds over G7 bonds over the past 12 years has been 4%,” Kresic adds. “Now, you are getting 5.75%, which is a good deal. But [emerging-markets bonds] are not for the faint of heart. There is more volatility in [these] bonds to come.

“Add to that the difficulties of trading emerging-markets bonds,” he continues, “and you see that they are for the nimble, the connected and the patient.”