As the credit meltdown intensified this week, investors are now reconsidering their allocations to emerging sovereign external debt after spreads this Monday widened to its highest levels in three years.
Fears over ever-tightening liquidity has aroused fears over the scale of risk-adjusted returns of the asset class as the endemic volatility shows no sign of abating – with some now touting local currency sovereign paper as potential safe havens.
Developing sovereign debt fell yesterday (Thursday) reversing the earlier gains spurred by the Federal Reserve unlocking the global liquidity gates after the colossal collapse of Bear Stearns.
As EuroWeek was going to press, emerging market bonds widened by 7bp to 3.12%, according to JP Morgan’s EMBI.
The yield on Ecuador’s 10% 2030 jumped 7bp to 10.52% while Venezuelan debt ballooned 20bp to 6.18%.
But on Monday, emerging debt widened to its highest levels since June 2005 at 17bp, 328bp over US Treasuries.
Fears over falling commodity prices and wounded exports from developing countries to a battered US economy triggered the losses.
Sovereign paper has generally outperformed following the deterioration of Western credit cycles, but market participants are now undertaking a whole scale review of the true impact of volatile risk appetite on credit fundamentals.
Merill Lynch now recommend investors step up exposure to liquid, high rated sovereign bonds that are deemed most immune to the global cyclical slowdown.
“Our cautious view on emerging market debt is becoming more negative on the back of further deterioration in the global financial system,” it said.
The bank downgraded Turkish, Colombian and South Africa credits this week to underweight as they have “overvalued currencies, current account deficits or increasing political noise”.
It upgraded Russian and Brazilian paper to overweight, citing “more solid fundamentals”.
The shop recommended investors to now actively differentiate names and take opportunities on a relative value basis.
“We are concerned that a confidence crisis could be more difficult to contain as investors take more time to discover good credits from bad.”
It also expressed confidence that the most liquid bond among emerging credits Brazil 2040s should continue to outperform, but argues there will be a near-term correction in Colombia’s bond performance.
“We think that a potentially more adverse external credit backdrop should be reflected in lower valuations for the bonds, given the credit's relative external vulnerabilities, including the peso's strong appreciation in the face of a growing current account deficit nearing 4% of gross domestic product.”
Nevertheless, despite the negative sentiment towards the asset class, Merill Lynch launched new local currency denominated emerging market sovereign indices this week.
The Local Debt Markets Plus Index, tracking sub AA3 rated countries with $10 billion in outstanding local currency denominated sovereign debt, has doubled in size to $1.4trn at the end of last year compared to $0.8trn since the end-2005.
This is four times the size of external sovereign debt of the issuers comprising the index.
Over the same period, accounting for costs incurred after hedging currency risks, the index returns 5.89% compared with external emerging sovereign debt that posts an annualized return of 7.45%.
However, the local bonds have recorded this profit with significantly less volatility at 0.66 compared with 1.39 for cross-border issues, with latter particularly correlated with the wavering appetite for high yield-credits globally.
“As a result, when compared against a variety of major high and low grade global fixed income asset classes, the local index ranks second (to the external debt index) in terms of average monthly return, but first in terms of risk-adjusted return,” said Philip Galdi, head of Merrill Lynch’s Global Bond Index Group.
He added: “This all suggests that there are portfolio diversification benefits to be gained by expanding into the local debt markets asset class.”
One banker argued that investors should now position themselves to beef up their exposure to local sovereign markets and have a hold-to-maturity attitude banking on the lucrative proceeds of currency appreciation.
However, another New York-based DCM banker argued illiquidity and the costs of hedging exchange rate risks would undermine the bull-run for local government paper in the near-term.
“For an investor perspective, this index does not provide enough historical evidence to take the gamble and all bets are off in this illiquid environment.”