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The Emerging Market Bond Bubble

The first quarter of 2010 saw record issuance of emerging market bonds.  It also saw the spread on those bonds fall to only 2.57% over the US Treasury rate, according to the Financial Times (see “Emerging market bond sales hit record high“).  The FT writes,

Sovereign bond markets in developing countries have seen a record $129bn in new deals so far this year, a 42 per cent increase over the same period last year, the previous record for issuance, according to Dealogic.

Emerging market yields narrowed to 2.57 percentage points over US Treasuries on Monday compared with 3.5 percentage points a month ago, according to JPMorgan’s Embi+ index…

That is a sharp fall from the recent cyclical peak of 6.84 percentage points in March last year and just a fraction of the all-time peak of 16.64 percentage points over US Treasuries in September 1998.

Risk appetites have certainly returned!

There are several ways this data can be interpreted.  One contrarian view I’ve seen is that the spread between U.S. and emerging market debt has narrowed not because emerging markets are seen as safe but rather because the U.S. is now seen as more risky.  This is ridiculous, of course.  American bond yields remain ridiculously low, showing that for all the wailing and gnashing of teeth, bond investors do not view the United States as being risky.

An optimistic view would be that emerging markets has simply come of age.  They’ve emerged, and their bond yields now reflect the maturity of their capital markets and institutions.  The optimist in me would like to believe this.

But then, common sense intervenes.  Is a 2.57%  spread really adequate compensation for the additional risks associated with investing in emerging markets?  And isn’t this lax attitude to risk exactly how all emerging market debt crises start?  And how we got into the mortgage / housing mess here in the U.S.? 

And of course, the elephant in the room is what happens if/when the Federal Reserve raises interest rates?

At any rate, in the emerging market bond sector, we have two factors that, when put together, warrant caution: record issuance (rising supply) and historically low yield spreads.   Prudent investors should seek yield elsewhere.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy