Markets

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

Brazil’s latest crisis serves as an important test for credit investors.

Debt buyers piled into emerging markets at an accelerating pace this year.

Winning Cash
Emerging markets funds have attracted a disproportionate amount of money this year
Source: Bank of America Merrill Lynch research, EPFR Global data


But now, are they willing to keep ignoring the fragility of some developing markets just to earn a little extra yield? Based on the initial reaction to the latest news out of Brazil late Wednesday, perhaps not.

Brazil’s markets plunged Thursday after reports that its president, Michel Temer, approved illegal payments to a disgraced lawmaker, raising questions about how long he can remain in office. The cost to insure against losses in the case of a Brazilian default surged.

Getting Pricey
The cost to insure against losses on Brazil debt surged on Thursday
Source: Bloomberg

The real plunged. The nation's stock market tanked. And the biggest exchange-traded fund that focuses on emerging markets, iShares J.P. Morgan USD Emerging Markets Bond ETF, had its biggest one-day decline since December.

Sudden Drop
The biggest emerging-markets debt ETF fell the most since December on Thursday
Source: Bloomberg

Emerging-market traders told Ye Xie of Bloomberg News that trading has all but evaporated in Brazil's cash-bond market. Meanwhile, its assets have been a popular trade this year, with few investors making bearish bets on the nation, leading to an even more one-way crowd on the way out.

It shouldn't be all that shocking that Brazil still has some fundamental political problems. Remember, it was only last year that Temer took over as president after the former leader, Dilma Rousseff, was booted from office. And don’t forget the corruption investigation into the state oil company Petroleo Brasileiro.

Despite all this background drama, Brazil's government bonds have gained 9.3 percent so far this year through Wednesday, with its currency gaining 4.7 percent, according to Bank of America Merrill Lynch index data. Debt of Petroleo Brasileiro has returned more than 10 percent since the end of December.

Brazil and other developing economies have been attracting a greater proportion of investor money this year for a variety of reasons. The chief benchmark interest rates are still low, leading traders to seek higher returns in less traditional places. The global economy is generally expanding, with some emerging economies growing faster than developed ones. And the dollar has weakened, which is generally a positive for other nations that have borrowed an increasing amount of money in the U.S. currency.

But investors are earning a shrinking amount of extra yield to own bonds tied to less-established countries.

Narrowing Benefits
Investors are earning less and less extra yield to own emerging-markets debt
Source: Bank of America Merrill Lynch index data

They have also at times seemingly ignored some fundamental challenges. These nations have been adding leverage. They're more susceptible to unpleasant surprises out of China or other large economies. And some, like Brazil, have some serious political and fiscal challenges that can easily erupt in ways that could impede the functioning of their capital markets.

This isn't to say all emerging-market debt is unduly dangerous or lacks value. But Brazil shows how some investors are rushing into less-developed markets without a full understanding of all the risks. They're racing into broad emerging-market funds and have been shown to be more prone to pulling their cash out in mass when the tide turns.

The latest political eruption in Brazil is a test of the strength of the stomachs of credit investors who've been touring in emerging markets. So far, it looks as if there are many queasy bond buyers out there.

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