Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Remember when emerging-market debt investors used to fret about Federal Reserve interest-rate hikes?

Remember the Tantrum
Emerging-market bonds plunged in mid-2013 amid the so-called taper tantrum
Source: Bloomberg Barclays index data

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.

Shrinking Premium
EM bonds are yielding the least relative to similarly rated U.S. debt since 2013
Source: Bloomberg Barclays EM Hard Currency Aggregate Index, Bloomberg Barclays US Corporates BBB ex Financials Index
The gap is between option adjusted spreads on the EM and U.S. corporate notes

Dollar-denominated bonds of developing nations are performing better this year than U.S. investment-grade and high-yield corporate credit.

Winning the Race
Emerging-markets bonds have gained more than U.S. corporates so far this year
Source: Bank of America Merrill Lynch index data
That's right, U.S. investment-grade bonds have returned exactly nothing

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.

Slippery Slide
EM bonds will likely be disproportionately affected if energy prices decline further
Source: Bloomberg

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.

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:
Mark Gongloff at mgongloff1@bloomberg.net