Emerging-Market Junk Bonds Falter Before Date With Fed Rates

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Investors’ craze for the bonds of junk-rated emerging markets is fading.

High-yielding securities from countries including Russia and Hungary posted the biggest advance in at least six years relative to notes of investment-grade nations in the first seven months of 2015, according to data compiled by Bloomberg. Yet, in the closing days of July, junk bonds began falling faster than higher-rated securities as fund managers expressed unease that the rally had gone too far.

While the higher coupon rates of junk bonds initially appealed to investors concerned about an increase in U.S. borrowing costs this year, that advantage narrowed as the notes continued to rise. Now bondholders have begun to wonder whether the thin cushion provided by their extra yield is worth the risks associated with them. The outlook is clouded by stumbling economies, heightened political tensions and shrinking scope for monetary-policy support.

“Is it sustainable and based on fundamentals? No, it is not,” Lutz Roehmeyer, director, fund management at Berlin-based Landesbank Berlin Investment GmbH, said on July 29. “It has to end sooner than later. Fundamentals in emerging markets are deteriorating at the moment.”

The average yield on junk-rated bonds in developing nations has dropped 86 basis points this year to 7.09 percent, compared with an increase of one basis point to 3.95 percent for investment-grade securities. Even so, the rate on high-yielding notes has risen five basis points more than the higher-rated bonds since July 17.

Economic Backdrop

Few economic factors have been supportive of the rally in high-yielding bonds. Russia is heading for a recession and a key driver of global demand, China’s economy, is slowing. Countries from Egypt to Nigeria remain vulnerable to capital flight when the Federal Reserve raises rates.

Still, the appeal of emerging-market junk bonds after losses last year trumped any concern bondholders may have had with their issuers. The yield on a Bloomberg gauge of high-yielding bonds sold by developing-nation governments increased 61 basis points in 2014, compared with a drop of 34 basis points for a similar index of investment-grade notes.

Five-year Russian bond yields doubled last year as fighting raged in Ukraine and crude-oil prices almost halved. Investors dumped the country’s bonds after it was downgraded to junk status by Standard & Poor’s and Moody’s Investors Service.

Higher Allocations

The turnaround came when funds looking to minimize losses in an increasing-rate environment increased allocations for high-yielding assets. Russia garnered some of that money.

“Russia is clearly responsible for this amazing outperformance,” Sergey Dergachev, a senior portfolio manager who helps oversee $13 billion of emerging-market debt at Union Investment Privatfonds GmbH in Frankfurt, said on July 29.

The gains for Russia peaked in May and five-year yields have traded in the range between 10.49 percent and 11.38 percent for the past 12 weeks. Now, investors have found other bright spots such as Ukraine, whose bonds returned more than 11 percent in July amid optimism it will succeed in restructuring its debt. Ghana, Rwanda and Hungary also led gains.

‘More Gains’

Some bondholders are betting that the high-yield grouping will continue to find such pockets of opportunity for some more time if political conditions don’t worsen.

Landesbank is adding bonds of oil-exporting nations including Russia, Angola and Colombia after declines led by cheaper oil prices, Roehmeyer said.

Concerns are mounting over the outlook for most of the junk-rated nations. Crude oil posted the biggest monthly loss this year in July, dragging Russian bonds down. Hungary’s central bank ended a five-month long easing cycle, while Ukraine had less than a month to finalize a deal with creditors.

The yield on the junk bond index is heading for a third week of increases, trading four basis points above the level on July 1. To some, that is a sign of exhaustion.

“It was good while it lasted, but now try to be a bit more defensively positioned within high yield,” Zsolt Papp, a money manager with JPMorgan Chase & Co. in London, which oversees $43 billion of fixed-income emerging assets, said by phone on July 30.