Emerging market bond markets are vulnerable to further interest rate rises in the US, analysts have told GlobalMarkets, warning of an alarming disparity between a hot market and declining credit quality.
Moritz Kraemer, global chief ratings officer at Standard & Poor’s, said that “as long as the debt accumulation goes on, the bigger the risks will be when rates do rise”.
Many investors claim to be calm ahead of an expected 25bp hike from the Fed in December — despite the severe sell-offs that followed the Fed’s announcement it would begin tapering in 2013, and its previous rate hike at the end of 2015.
And if fundamentals do not improve, the market remains susceptible.
“Worries about Treasury rate rises are absolutely not misplaced,” said Paul Tregidgo, vice chairman of debt capital markets at Credit Suisse. “No matter how much expectations are managed or how well hikes are telegraphed, there is such a complex set of considerations that investors have to be prepared to move quickly.”
Until it is clear that economies are growing again, “EM markets are going to continue to be buffeted around by one factor or another”, Tregidgo said.
A report from S&P this week showed that nine of the largest 20 emerging market sovereign issuers — measured by amount of debt outstanding — had negative outlooks from the agency. Just two had positive outlooks.
At the same time, global monetary easing continues to drive a search for yield that is permitting broad bond market access even for the riskiest of credits. Ecuador, for instance, raised $1bn of notes due 2022 in September, paying a whopping 10.75% of interest.
“As spreads tighten, we are seeing weaker credits issuing in EM, and it is starting to feel unsustainable,” said Sarah Glendon, head of emerging market research at Gramercy.
“What seems distorted to me is that spreads suggest that a lot of EM names are getting stronger rapidly, but — in Latin America at least — there are very few fundamental stories markedly improving.”
STAMPEDE TO THE EXIT?
But it is an EM-wide problem. Kraemer said that the sovereigns that relied on foreign funding were most at risk. “The Philippines and China, for example, but South Africa and Turkey do [rely on foreign funding] big time,” he said. “These are the sovereigns that might be caught in the crossfire when rates increase in the US.”
Another EM fund manager said he was not worried about an immediate hike, but by the prospect of the indication of a more aggressive tightening cycle.
“In the worst-case scenario, there’d be a stampede to the exit,” Kraemer said. “That is why the process is as gradual as it can be.”
When the Fed has previously signalled a tightening in monetary policy, local currency debt has suffered even more than hard currency. This could exacerbate the issue.
“EM has a very big debt problem, a domestic debt problem,” said Robert Waldner, chief strategist at Invesco. “We need a long period of deleveraging, where countries work down debt levels.
“In that period we’re going to see defaults and deflation, and that makes for a hard time. Growth is slowing; debt is growing. It is not a crisis, but it’s an on-going EM headwind.”