From Papua New Guinea to Argentina, Bond Risks Are Going on a World Tour

  • Investors desperate for yield willing to tolerate more risk
  • Junk bonds now make up half of benchmark emerging-market index

A serial deadbeat got investors to buy 100-year bonds, Sri Lanka’s latest debt sale was oversubscribed by 10 times and tiny Belarus is poised to issue eurobonds.

That’s just a small sampling of the risks emerging-market investors have started taking, even as yields remain relatively thin.

Here’s more: defaulted notes from Mozambique are among the best performers in 2017. The Maldives, a tiny nation in the Indian Ocean, sold its first international bond earlier this month. And Ecuador, where the former president disparaged bondholders as “true monsters” when he defaulted in 2008, had no trouble raising $3 billion.

What’s even more amazing than investors’ tolerance for these risky issuers is how little compensation they’re demanding in return. While bonds rated below investment grade now make up less than half of Bloomberg’s emerging-market sovereign index, down 14 percentage points from 2013, the sketchier credits aren’t resulting in any extra return for investors. Spreads over U.S. Treasuries, while still above the levels seen before the 2008 financial crisis, are near the tightest in three years.

“I’m guessing the alarm bells are ringing, and in many ways it feels like 2007,” said Anders Faergemann, a senior fund manager in London at PineBridge Investments, which oversees about $80 billion globally. “Dedicated EM investors are dancing ever closer to the exit door, but for those of us who were around in 2007 there was a long period in which EM continued to rally even though valuations were stretched.”

The disconnect is a result of historically low interest rates worldwide -- notes in Japan, Germany and France have negative yields -- as well as what skeptics see as investors’ complacency as they pour into index-based funds without scrutinizing their holdings. Borrowers are thrilled. Developing nations have issued $41.6 billion in hard-currency bonds this year, a record and up 20 percent from the same span last year.

And there’s more to come. Papua New Guinea, the impoverished Pacific Island nation, is planning its overseas debut in the second half. Belarus has hired banks to arrange investor meetings. Tajikistan reportedly intends to sell $1 billion in international notes.

Low market volatility has spurred a “torrent” of capital flows into emerging-market debt, reflecting investor complacency and “excessive risk taking,” Bank of America Merrill Lynch strategists led by David Hauner in London wrote in a report last week. He warned that the second half of the year should bring challenges for lower-rated issuers as higher interest rates in the U.S. reduce some of the appeal of junk credits with relatively steep interest rates.

But as long as borrowing costs remain suppressed in much of the developed world, investors are willing to tolerate increasing amounts of risk. Bond buyers now get just 3.2 percentage points in extra yield to hold emerging-market government bonds instead of U.S. Treasuries, down from as high as 5.25 points as recently as early 2016.

“There’s this voracious hunger for yield,” said Robert Abad, who runs the emerging-market consulting firm EM+BRACE and has covered the sector since 1991. “The market is at a point where we haven’t hit a real bump in the road to wake everyone up.”

Emerging-market debt has also broken its historical link to commodities, and particularly oil. While it used to be that investors could count on a drop in energy or grain prices to hit assets from countries that rely on raw-materials exports, that hasn’t happened this year.

The shrinking spread has continued this year even as rating companies sound alarm bells. Among major emerging markets, Moody’s Investors Service, S&P Global Ratings and Fitch Ratings have either cut grades or lowered their outlooks on Qatar, South Africa, China, Brazil and Turkey this year, while just Indonesia and Argentina have gotten upgrades.

Even after the bump, Argentina is still rated five levels below investment grade. But with its century-bond sale, a country that spent 75 years of its two-century history in default has convinced investors its track record is no cause for concern. The leap of faith came just 14 months after Argentina issued its first international bonds since a 2001 economic collapse that resulted in a record-setting $95 billion default and years of litigation with creditors.

Roberto Sanchez Dahl, a Boston-based money manager at Manulife Asset Management, which oversees about $4.5 billion of emerging-market debt, said there is still plenty of value in bonds from some developing nations. While yields are low on an absolute level, there’s an argument to be made that spreads for junk and investment-grade emerging-market bonds are still historically wide relative to their U.S. peers, he said.

“There are some very difficult cases in high-yield EM, but you also see improving stories like Argentina, so you can’t generalize,” he said in an interview. “Instead, investors should assess where there are pockets of risk and where there are opportunities.”

Argentina’s bonds were sold to yield about 7.9 percent, which compares with 2.75 percent for a 30-year note from the U.S. government. Sri Lanka’s new 10-year securities yield about 6 percent. The five-year note from the Maldives pays 6.8 percent.

Those interest rates show that strong investor appetite for the worst emerging-market credits is driving payouts ever lower. Notes rated B-, B or B+ now yield 6.56 percent on average, about half as much as they did in early 2014, according to JPMorgan Chase & Co. The MSCI Emerging Markets Currency Index was little changed as of noon in New York, maintaining this year’s advance of 5.6 percent.

"I did laugh a little when I read about the 100-year bond and asked myself whether this marked the top of the EM bond market cycle," said Koon Chow, a strategist at Union Bancaire Privee Ubp SA in London who added that Argentina’s bonds were still appealing on a relative basis. "I think EM credit, especially sovereigns, had run a bit too far in general.”

— With assistance by Ben Bartenstein, Aline Oyamada, and Yumi Teso

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