Emerging-Market Bonds: The Ride Just Got Bumpier

But many issuers should be able to survive higher rates

Emerging-market bonds sizzled for the past year, as interest rates in U.S. Treasuries dropped to the lowest levels in decades. But now U.S. rates are moving up, and that can have wide repercussions in the emerging markets. The last time U.S. rates ran up sharply -- from 3% to 6% in 1994-95 -- the shift wreaked havoc. Worst hit was Mexico, where investors dumped billions of dollars of risky, short-term, dollar-denominated debt, triggering a disastrous economic meltdown that spread throughout the developing world.

A recent sell-off of Brazilian debt and currency has investors concerned that a similar scenario may unfold this year. "It will be a bumpy ride," says Mohamed El-Erian, who oversees more than $14 billion as emerging markets chief at PIMCO.

This time, though, the impact will probably be far less dramatic than a decade ago. For starters, few experts believe U.S. rates will rise even a full percentage point this year. More important is the fact that many developing countries have taken advantage of low rates to refinance and reduce their debt burden. What's more, prices for the oil, soybeans, copper, iron ore, steel, and other commodities these countries produce are near record highs, so borrowers have plenty of cash. "The market is in better shape than it was in 1994," says Michael Conelius, manager of the $250 million T. Rowe Price (TROW ) Emerging Markets Bond Fund. "All of the important countries built up massive reserves. That's a nice cushion in a higher rate environment."

In fact, credit quality in the emerging markets is so strong that nearly half of the 31 countries in the JPMorgan (JPM ) Emerging Market Bond Index carry a coveted investment-grade bond rating. In 1994, almost 98% of the countries in the index were junk issuers.

That doesn't mean there won't be any pain. Higher rates would crimp growth. And a slowdown in China could push down commodity prices, hitting parts of Latin America and Russia especially hard. Timing emerging markets has never been easy, but buying on the dips might be a smart move.

YELLOW LIGHT

Issuers are racing to lock in low rates before the Federal Reserve takes action. In Russia, where the government is issuing very little debt, oil producer Gazprom offered $1.2 billion of debt in April, and investor interest was high. But while Brazil already has issued about half of the $5.5 billion it needs to raise on international markets this year, it continues to be the country investors worry about most. Huge public-sector debt, equal to 58% of gross domestic product, would be hard-hit by a gain in U.S. rates. Brazil "is a yellow light; it has to be watched fairly closely," says Christian Stracke, emerging-markets analyst for CreditSights.

In addition to Brazil, T. Rowe's Conelius says Turkey and the Philippines are on shaky ground. All three countries "have reasonably large borrowing needs," he says. PIMCO's El-Erian is equally concerned about Venezuela. "Despite high oil prices, it's running a deficit," he says. "That's not good domestic policy." Mexico, which has overhauled its economy, and South Korea are safer bets. But while these countries are less risky, they offer lower yields.

The ride may not be as rough for emerging markets as it was in the '90s. But seat belts might be useful anyway.

By Geri Smith

With Jason Bush in Moscow, Jonathan Wheatley in São Paulo, and Lauren Young in New York

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE