Emerging market bond investors, having enjoyed good returns for several years, were jolted in May when the chairman of the US Federal Reserve hinted that the days of quantitative easing were numbered, sparking a mass sell-off of their assets. Was it a temporary blip, or is the emerging market party finally over?

For emerging market debt investors, there seemed to be little to worry about. The previous 12 months had given them scant reason to think that conditions were about to turn for the worse. Returns on fixed-income assets from across eastern Europe, Asia, Latin America and Africa were high. Demand was so strong that several new borrowers, who would not have had a look in even a few years ago, were able to access the international markets, the results often being spectacular.

Zambia, a B rated southern African country with a per capita gross domestic product (GDP) of less than $2000, garnered a huge $12bn of orders when it issued a debut Eurobond of $750m in September 2012.

The beginning of the end?

But this stability vanished in May. US debt markets, which had been jittery since the beginning of that month, became particularly nervous from May 22, when Ben Bernanke, chairman of the US Federal Reserve, told Congress that “in the next few [Federal Open Market Committee (FOMC)] meetings, we could take a step down in our pace of purchases”. The words may have seemed innocuous to politicians and the wider public, but to fixed-income investors they were the first signal from the Fed that it was considering ending its $85bn-a-month bond buying programme that it launched to stimulate the US economy.

The resulting sell-off was such that US 10-year treasury rates, seen as a benchmark for dollar-denominated bonds globally, widened in May, from 1.66% to 2.16%, a level that had not been reached for more than a year. And the rout did not stop there. By early July, 10-year yields had risen to almost 2.75%, which most interest rate strategists had predicted would not happen until well into 2014.

The volatility quickly spread to emerging markets. Almost without exception, the price of dollar bonds, including those of some of the biggest emerging markets, such as Russia and Brazil, fell sharply. South Africa’s 2022 Eurobond widened from less than 3% in early May to 5.2% in late June (see chart 1). Others were hit even harder – Senegal’s yields climbed 300 basis points (bps) in that period.

Indiscriminate sell-off

There was little discrimination between different assets. Brokerage firm Exotix says that the correlation between the price movements of 40 frontier market sovereign dollar bonds that it monitors – a basket comprising the debt of countries from Albania to Venezuela – rose to an almost unprecedented 87% shortly after Mr Bernanke’s comments (100% would imply perfect correlation). “At 87%, frontier market assets lose their own identity,” says Gabriel Sterne, senior economist at Exotix. “It didn’t matter what it was, people were just selling.”

Neither was local currency debt spared. Yields on Turkey’s 10-year lira paper soared from 6% to more than 9% between mid-May and mid-July (albeit the situation was made worse by nationwide protests). Brazilian real, Indonesian rupiah and South African rand paper also suffered (see chart 2).

Emerging markets have increasingly attracted portfolio investments in the past decade as result of their rapid economic expansion, improving fiscal management and low debt levels. Growth rates in developing Asia, Latin America and Africa have been far ahead of those in the developed world. And few countries in those regions have debt-to-GDP ratios of more than 50%, a position the US, Japan and almost all western European countries would envy.

Yet, the developing world's low interest rates and quantitative easing (QE) since 2008, especially in the US, were vital, too, in driving demand for emerging market securities. Amid record low yields at home, investors rushed into emerging markets in search of better returns. “The market had become overdependent on the liquidity injections,” says Bryan Pascoe, head of debt capital markets (DCM) at HSBC. “The value of assets and the risk-reward proposition were definitely skewed by the amount of liquidity in the system. Fundamentals alone just did not support the tight spreads in many asset classes.”

The sheer scale of asset purchases by the Fed meant that even though investors knew it would have to reverse its policy at some stage, they seemingly panicked at Mr Bernanke’s first mention of that eventuality. “It was almost a game of chicken,” says Mr Pascoe. “No one wanted to move first. But once the signal came, investors all tried to dash through the door at the same time.”

Others add that many in the markets were taken aback by the strength of the US economic recovery and decline in unemployment since the start of the year. “It did catch some investors by surprise,” says John Wright, a Barclays syndicate banker focusing on central and eastern Europe, the Middle East and Africa (CEEMEA). “There had been a decent stabilisation of US growth. But I don’t think anyone really expected to see the first signs of a reversal in the Fed’s policy so soon.”

African Eurobond yields; Emerging market local bonds

Next step

Investors will scrutinise the US central bank’s next actions, as any renewed volatility in treasury markets, which were largely calm in July and the first half of August, will quickly rumble through to emerging markets. “You cannot ignore the US,” says Simon Lue-Fong, head of emerging market debt at Pictet Asset Management. “Idiosyncratic factors definitely drive emerging market assets. But so do global macro factors, and the US is a big one of those.”

The Fed has not revealed how it will unwind, or taper, its QE programme. Many analysts think it could, depending on the outcome of non-farm payroll data released on September 6, announce a decrease of its bond purchases as soon as September 18, the day its next FOMC meeting finishes. “Given the economic environment in the US, it will be difficult for the Fed to justify its current level of asset purchases for long,” says Maya Bhandari, a global macro strategist at Citi.

How emerging markets react to monetary tightening will depend not just on its timing – some investors doubt the Fed will cut its bond acquisitions until December or even next year – but its extent, too. Interest rate strategists in the US think the central bank will initially decrease its purchases to $60bn or $65bn a month, before reducing them further in steps of about $20bn over the course of six months to a year.

Given the widespread talk about tapering since May, few expect the market’s response to be overly severe once it is officially announced by the Fed. “The rate market has mostly priced for the Federal Reserve to reduce purchases in the next five months,” says Ira Jersey, a rates strategist at Credit Suisse. “There will be some market reaction. But we’re talking about a 5bps or 10bps knee-jerk reaction, not a 40bps or 50bps sell-off [of US treasuries].”

Perhaps of more importance will be the central bank’s strategy once it has stopped buying bonds. If it raises the federal funds rate – effectively the base interest rate – from today’s target of zero to 0.25% too quickly, it could spark a bear run in treasuries and play havoc with emerging markets.

When to raise?

Mr Jersey believes there should be a long gap between the last bond purchases and the hiking of rates, even if the Fed uses reverse repurchase agreements and its term deposit facility to reign in liquidity in the intervening period. “An appropriate policy, once it is done with the bond buying programme, would be to wait at least six months, or even probably closer to a year, before [seeing if there’s enough] evidence to hike the federal funds rate,” he says.

The Fed, seemingly irritated by the fall in US bond prices after Mr Bernanke’s comments on May 22, subsequently stressed that it will keep rates low as long as unemployment, currently at about 7.4%, stays at more than 6.5%, which most investors think will be the case until late 2014, if not beyond then.

Investors have been relieved by those assurances. They say the Fed’s strategy must be to ensure that treasury yields rise smoothly, rather than in sudden bursts, over the coming two or three years. Thanasis Petronikolos, head of emerging market debt at Barings, a UK asset manager, is confident that the central bank will have learnt from past mistakes of not making the market aware of its intentions early on.

“I think we’ll avoid a 1994-type of scenario. Then, the Fed tightened monetary policy dramatically, taking markets by surprise,” he says. “This time, I think it will communicate any change in its stance well in advance because it would like to avoid market turbulence. The market will be prepared.”

Tougher conditions

The international bond market has become a tougher place for emerging market borrowers in the wake of May’s rise in US yields. Funding costs and new issue premiums have increased, while order books have shrunk. “Conditions are very different now compared with before the period of volatility,” says Barclays’ Mr Wright.

Bankers say some borrowers have been put off raising capital because of higher issuance costs. Reflecting this, John Rwangombwa, Rwanda’s central bank governor, told The Banker that the east African country, which sold a debut Eurobond with a yield of 6.875% in April, would have shunned the market had it needed to pay more than 8%, which by late June was where the deal was trading. “Today, the yield is not good,” he says. “We wouldn’t be thinking of coming to the market now.”

Yet the market is far from being shut to emerging market issuers. Investors have shown several times since May that they still have plenty of appetite for deals. Among the borrowers to sell large bonds between the beginning of June and mid-August were Israel Electric ($1.4bn), South African media group Naspers ($1bn), Ghana ($750m) and Bolivia ($500m).

The success of these deals has made investment bankers confident that the supply of emerging market Eurobonds will not drop much during the rest of 2013. “I don’t expect any significant slowdown in issuance from emerging markets – overall market conditions permitting – given that growth in them is running meaningfully above that of the developed world,” says Simon Ollerenshaw, head of CEEMEA DCM at Barclays.

That economic buoyancy has underpinned the increasing demand for emerging market debt in recent years, and continues to do so. Developing economies are expected to outpace the rest of the world for the next several years. US investment firm Franklin Templeton predicts that while real GDP growth in developed markets will be 1.1% in 2013, emerging markets will rise by 5.4%. “On average, the fundamentals in emerging markets are sound,” says Mr Petronikolos.

Less persuasive story

Nonetheless, many of the world’s major emerging economies have weakened in the past two years. China is decelerating, which is hurting the exports of other developing countries, including South Korea, which had to pass a supplementary budget of $15bn in April to boost its economy. India’s growth in the 12 months to the end of March – while still high at 5% – was its slowest in a decade. And Brazil and South Africa are expanding at barely 2%, far lower than what they managed in the 2000s.

“The perception is still that emerging market assets look good fundamentally. But the story’s not as persuasive as it was,” says Mr Lue-Fong of Pictet. “The combination of QE withdrawal and emerging market countries being on the back foot makes emerging market investors look a bit like salmon swimming upstream. In the short term, things will be a bit tricky.”

The situation is exacerbated by emerging markets’ trade positions having also worsened. The aggregate current account balance of all emerging states excluding China fell into deficit in 2012, the first time that had happened since 1999, according to Citi. And while public balance sheets might still look sound, private debt-to-GDP ratios have risen substantially in Brazil and much of developing Asia since 2000, fuelling concerns about credit bubbles.

“We are returning to a situation where emerging markets need money from the rest of the world, at a time when their fundamentals are worsening,” says Ms Bhandari. “It’s been a bull run for emerging markets for some time and that now looks to be over.”

Bankers say that countries with wide current account deficits financed mainly by foreign portfolio investors will be particularly vulnerable when monetary conditions in the US tighten. Among those they cite are South Africa, Indonesia and India, whose currencies and local bond markets have been under heavy pressure since May.

US recovery beneficial

Not all investors are gloomy about the end of QE in the US. Some insist that even if rising interest rates cause short-term ructions, emerging markets cannot but benefit from a stronger US economy in the longer run. Mr Petronikolos says that despite China’s rise, the US is still of such importance that the health of its economy affects the rest of the world to a large extent, in terms of both trade and financial flows.

“If the US economy returns to growth rates of 3%, that will be great for emerging market economies and assets,” he says. “The negative effect of the rise in interest rates will be offset by the positive effect of rising risk appetite for high-yielding assets when the US economy does well. The combination of low inflation and high growth in the US is the best possible external environment for emerging market assets.”

Barring an unexpected reversal in the US economic recovery, QE is on the way out, which will inevitably have significant consequences for bond markets globally. Some analysts think emerging market fixed-income returns will diminish as investors move their money back to rich-world countries. Others argue instead that emerging economies have not only become too big for investors to neglect, but that their growth rates will be sustained in the long term.

“The emerging market story isn’t a fad,” says HSBC’s Mr Pascoe. “There’s a move in wealth from West to East and North to South. In terms of demographics and wealth generation, the trends are still very much intact. So, there will be money dedicated to these countries throughout the cycle.”

For the latter group, the next year or two will provide a stern test, and one they hope will prove that debt markets in emerging countries can thrive and grow regardless of whether they are flooded with cheap money from the US.

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