Photo: joelaz on flickr
Europe is on the ropes as investors shun peripheral euro-area government debt. In the United States, interest rates are fixed at zero, and government bonds are arguably already quite far along in an epic 30-years-and-running bull market.Given the state of global debt markets and the apparent lack of value across the investment landscape, it’s easy to see why interest has turned to emerging economies.
Gabriel Sterne, an economist at the frontier-market brokerage firm Exotix, told Business Insider, “You get some of these big funds – a lot of the funds in the States – just getting these inflows every month. What do they do with them? They tend to just double up and put them in [emerging markets].”
Sterne went on, saying, “In the absence of any bad news, there is not enough supply out there, so yields just fall down.”
UBS rates strategists Bhanu Baweja, Stephen Mo, and Nicholas Smithie were lamenting the lack of “distressed” investment opportunities around the world right now – given all of the recent interest in EM debt and assets – in a note to clients Wednesday.
The strategists highlighted a major dilemma that investors in emerging markets now face:
Consumer staples in EM trade at 20 times future earnings. Mexican stocks are 33% above pre crisis highs, South African equities are impervious even as the weakness in the labour markets become manifest. Implied currency volatility is at post crisis lows despite the trade cycle remaining very weak.
10 year paper of some non investment grade sovereign names in Asia trades at a spread well below 100 bps. Ukraine debt has been amongst the top performers in recent months with little to show for it from within the country. Bolivia can issue 10y paper below 5 pc. We can honestly say that we would not have predicted 5 years back that this day would come.
There are worse things in life than being an asset manager sitting on continued inflows, but given where assets trade, security selection can’t be that straight forward today. Are things getting silly, and if so, is that true across all asset classes? Is anything still distressed out there?
In other words, it’s getting harder and harder for investment managers to find good value opportunities in emerging markets as money flows into those economies.
The issue is particularly acute in EM debt. The chart below the overwhelming investor preference for EM debt (as opposed to equities) in recent years:
As a result, the UBS strategists conclude, “we don’t think such a thing as distress is still around in EM assets, but to the extent it exists there is more of it in EM equities than in EM debt.”
Sterne, whose clients at Exotix are typically looking for investment opportunities in frontier markets – economies not even developed enough to be considered “emerging” – told Business Insider that clients are going to extraordinary lengths to find value.
“We’ve got quite a repeated trade recommendation – the more [the EM rally] goes on, the more the less liquid stuff gets hit, and it’s fairly predictable, actually. Now, we’re up to the last vestiges – it’s like the Bosnias and the Seychelles that haven’t yet been tightened in. The really illiquid stuff looks like really good value at the moment, because it’s not quite hit them yet,” said Sterne.
Sterne told Business Insider that Exotix just promoted Bosnian and Seychelles sovereign debt to its “top-5” list, “just kind of on a valuation basis.”
Of course, larger players on Wall Street are largely responsible for enabling the rapid push into EM investments in some cases. All a global investment banking giant like Citi or JPMorgan has to do is add a country’s bonds to the bank’s benchmark fixed income indices, and the money follows.
South Africa is one recent example. On April 17, 2012, Citi announced that South African government debt had become eligible for inclusion in its World Government Bond Index (WGBI).
BNP Paribas head of CEEMEA strategy Bartosz Pawlowski told Business Insider that following the Citi announcement, there was a mad rush into South African debt.
“It was buyers galore. Flows were amazing,” Pawlowski said.
The chart below shows the three-day moving average of bond flow data (in millions of South African rand) from Bloomberg.
Photo: Bloomberg, Business Insider
Flows have been fairly robust since then – and South African bonds weren’t even actually added to the benchmark index until October 1, which means all of that money moving into South African debt has simply been in anticipation of the addition to the index.
If the chart above doesn’t get across the effect of the change, compare the average daily flows year-to-date before and after the announcement. That figure more than doubled to an average of $59.9 million in inflows per day – from $27.9 million before April 17.
Amazingly, this has continued even in spite of the massive labour unrest that crippled the mining industry in recent months and almost brought the South African economy to a grinding halt when transport unions joined in.
Elsewhere on the continent is Nigeria, a country which, like South Africa, has recently seen increased interest in its sovereign bonds from foreign investors lately.
The effect on Nigerian borrowing costs has been remarkable, and FBN Capital’s Gregory Kronsten expects that interest to continue:
The announcement in August by JP Morgan that three FGN bonds would be included in its government bond index with effect from the start of October prompted a rally in the market. Yields narrowed by up to 300 bps as offshore investors, many new to Nigeria, entered the market.
It was estimated that index investors would have to commit about US$1.5bn merely to give Nigeria a market weight. There has been some profit-taking but we see further legs to the rally, not least because of improved inflation prospects.
Yields fell 3 per cent on the JPMorgan news in August. In September, we were highlighting the tumultuous security situation in Nigeria, which David Kotok called his biggest fear for the global economy.
For now, though, money keeps flowing into Nigerian bonds as investors reach for yield anywhere they can find it.
Sterne told Business Insider that investor interest in emerging markets right now really shows no discernment:
Basically, it’s been hugely correlated…We have our own index of 40 of the less-liquid EM (but if it’s 40, it does cover quite a few of the relatively more liquid ones). The correlation there has been getting again toward 60 per cent across the whole lot of them in the last couple of weeks. It’s a very correlated risk-on rally. I definitely think it’s an “asset class feature” that’s going on at the moment.
One of the biggest risks to investors in emerging market debt is the economic instability that results in small economies as all of this investment money flows in without restraint. We will examine that issue in an upcoming post on Money Game >
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