Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Not all bond selloffs are created equal. Some mean investors are deserting the asset class, others that they are just seeking protection, even if they may be shooting themselves in the foot in the process.

This emerging market debt rout has all the marks of a defensive move -- though if it continues it could easily unravel into a proper panic.

Picture of a Tantrum
Developing nation bonds have been selling off heavily since Donald Trump was elected U.S. president
Source: Bloomberg

While developing nation bond indexes have been showing steep losses, the moves aren't across the board: Countries and companies with more debt outstanding have been leading the pack. That's partly explained by the fact that when funds are hit with redemptions exceeding the cash set aside for the purpose, they have to sell assets -- and larger, more liquid bonds are the easiest to unload.

It's easier to part ways with a security for which there is plenty of supply than with one that may not be offered again anytime soon. The perfect example is what's happening in Vietnamese versus Brazilian bonds. The yield on dollar debt from Brazil increased 87 basis points since Donald Trump's election, while Vietnamese notes for almost the same maturity rose only 50. That's in spite of the South American country's higher rating and lower dependence on trade with the U.S.

Short the Big
Brazil has more than $45 billion of U.S. dollar bonds versus just over $2.2 billion for Vietnam. Investors are selling the former, even though it has higher ratings and may do better during a Trump presidency
Source: Bloomberg

Clearly, the reason is more practical than fundamental. It isn't just that the bigger bonds are easier to sell, both in markets and psychologically. Debentures, unlike stocks, don't trade so often, especially in emerging markets, and usually the only securities that allow shorting are those with several billion dollars outstanding. Risk management, therefore, is much to blame for the recent spike in volatility.

Ironically, the developing bond selloff may be spurred partly by defensive activity in a different corner of the market. Much of the almost $14 trillion in mortgages in the U.S. is held by investors who use the yields on 10-year Treasuries as their benchmark. When that increases, the cost of refinancing homes goes up. That in turn changes assumptions about when people will pay back their loans.

To mitigate the risk of being stuck for longer with a loan at a rate that's lower than the current market, mortgage investors short the 10-year Treasury bond. That usually accelerates the decline in price and creates a vicious circle until someone decides U.S. government debt has become too cheap and steps in. This process may help explain why the 10-year Treasury yield has increased 34 basis points in less than a week. 

It was that steep rise that sparked the alarm bells for risk managers at emerging market funds and unleashed their own shorting. Once their defensive allocations are done, prices should find a floor. For now, at least.

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

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net