Emerging-Markets Mania Threatens to Burn Out

Rally has pushed yields closer to those of developed countries.

It's hard to overstate the amount of money that has been rushing into the debt of developing nations.

The biggest exchange-traded fund focused on emerging-markets bonds has almost doubled its assets this year, data compiled by Bloomberg show. 

Cash Surge

Assets in the biggest emerging-markets debt ETF have almost doubled this year

Source: Bloomberg

Dollar-denominated debt of developing economies is poised for its best annual return since 2009.

Emerging Boom

Dollar-denominated emerging-markets debt is poised for its best annual return since 2009

Source: Bank of America Merrill Lynch index data

Yields on the debt have dropped to the lowest in more than three years.

Cheaper Money

It's the least expensive for developing nations and their companies to borrow in three years

Source: Bank of America Merrill Lynch index data

The good news for this rally is that cash just keeps pouring in, fueling some momentum, at least for the time being. After all, where else can investors go to earn some income on their debt investments? Yields in developed markets are hovering near record lows or setting new ones, forcing bond buyers to get more creative if they want to earn any income at all. 

The bad news is that the main rationale for buying emerging-markets debt is quickly becoming obsolete. These bonds have rallied so sharply that, in several cases, they're not offering that much more yield compared with similarly rated developed-market debt.

Consider, for example, dollar-denominated junk-rated debt of emerging markets companies. Investors are demanding the smallest premium to own these notes relative to similarly-rated U.S. ones since 2013, according to Bank of America Merrill Lynch index data.

Losing an Edge

Investors aren't earning as big a premium to own emerging-markets bonds as they were in recent years

Source: BofA Merrill Lynch Diversified High Yield US Emerging Markets Corporate Plus Index, US High Yield Index

And, of course, there's the slight problem of fundamentals, which aren't improving much for countries that have benefited the most from this year's rally. The biggest winner, for example, is debt of Brazil, which is mired in its worst recession in decades. A close runner-up is debt of Venezuela, where residents are forced to wait in seemingly endless lines for a chance to get food and pharmaceuticals, sometimes to no avail.

Dangerous Attraction

Investors have poured money into developing nations, even those mired in financial crises

Source: The BofA Merrill Lynch US Emerging Markets External Debt Sovereign & Corporate Plus Index

Yet another potential dark cloud is a solid U.S. economy. Last week's positive jobs report has some analysts predicting that the Federal Reserve will raise rates sooner than the market is expecting. That would bode poorly for developing-markets debt, which has become increasingly vulnerable to U.S. policy shifts

Meanwhile, companies in developing nations are selling bonds at a near-record pace, with $39.6 billion of such sales last month, CreditSights data show. This adds to the more than $18 trillion of emerging-markets corporate debt outstanding, an amount that has more than quadrupled since 2004, IMF data show.

Longer term, the growth in emerging-markets sovereign and corporate debt may prove to be somewhat problematic, potentially exacerbating any hiccups in the global economy. The longer this hot money flows into emerging markets, the more vulnerable the nations' debt looks.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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