Emerging Market Debt Is Safer Now (Unless ...)
Remember when emerging-market debt investors used to fret about Federal Reserve interest-rate hikes?
Apparently, they don’t care anymore, or at least not very much.
Even though it’s almost a sure thing the Fed will bump up overnight borrowing costs next week, investors are racing into these bonds. Funds focused on this debt received more than $2 billion of deposits in the past week, the second-biggest flow in 2017, according to Wells Fargo Securities analysts.
Investors are demanding the lowest amount of extra yield to own these notes relative to similarly rated U.S. debt since 2013.
Dollar-denominated bonds of developing nations are performing better this year than U.S. investment-grade and high-yield corporate credit.
This all comes as developing nations build up record amounts of dollar-denominated obligations. This makes them more vulnerable if the greenback strengthens -- as many expect it to do as the U.S. central bank tightens monetary policy. Meanwhile, any global economic downturn tends to disproportionately harm these nations, which rely on faster growth.
That sounds pretty bad, and it would be easy to dismiss this rally as a display of irrational exuberance, with debt buyers simply blindly searching for extra yield.
But that's too simplistic. This rally, especially in the face of a Fed rate hike, marks a pretty profound shift. As my Bloomberg Intelligence colleague Damian Sassower has pointed out, these nations have changed. They’ve developed. They’re also very different from one another. With more than 80 countries included in the Bloomberg Barclays EM Hard Currency Aggregate Total Return index, it’s a more diverse universe than, say, a corporate credit index reliant only on the U.S. or Europe or Japan.
And these smaller nations tend to be less leveraged than bigger, more established ones, which have relied heavily on non-traditional stimulus efforts that caused their debt outstanding to balloon. Meanwhile, the global economy suddenly looks more resilient than it did just a year ago, with inflation picking up and signs of sustained growth.
So while emerging-market debt isn’t immune, it seems less vulnerable than it used to be against selloffs in developed markets.
There is, of course, a catch. Many of these bonds are in a vulnerable position if oil prices materially weaken.
More than a quarter of dollar-denominated corporate and quasi-sovereign debt in emerging markets is tied to oil and gas production, according to Bloomberg Intelligence. That compares with 14.4 percent of the U.S. high-yield index and 12 percent of U.S. corporate bonds more broadly.
Bonds in Russia and Qatar -- of Lukoil and Ras Laffan LNG, for example -- may be particularly vulnerable because they rely on oil revenues as well as national economies that are highly dependent on the same type of income.
When the Fed raises rates next week, emerging-market credit can easily keep on rallying. It's really falling oil prices that would put a halt to this party.
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