Fears grow of emerging market debt bubble

Emerging Markets ADB editions, May 3 2013

Fears are growing of a bubble in emerging market debt as a combination of record lower-rated issuance and unstoppable capital inflows dominate the market.

As yesterday’s Emerging Markets reported, capital inflows into Asian assets are gaining renewed momentum through monetary easing in the EU, Japan and US, while high yield bond issuance in Asia so far this year has already trebled the full-year total for 2012 to meet the demands of investors hungry for yield.

This ardour, though, is worrying some investors who fear a bubble in emerging market debt. “I’m told Ukraine has seen the issuance of 10 corporate dollar bonds so far this year, Rwanda’s 10-year debut bond came in below 7% yield despite its single B rating, and Nigeria’s 2021 dollar bond yields 4%,” said Charles Robertson, global chief economist at Renaissance Capital. “What we are now getting very close to is a local currency bond bubble too.”

For example, Robertson said that local bond flows in to Turkey were $223 million in January to February 2012, and in January to February 2013, $4.53 billion – a 20-fold increase in a year. Russian foreign ownership of the local bond market had boomed from almost nothing to 15% within a year, he added, while the yield on the local 10-year bond had dropped to 6.7% in a country with headline inflation at around 7%. “But foreign ownership [in Russia] could double again,” he said. Dropping yields and booming foreign ownership created a good case to switch to equities, he said.

Debt capital market bankers in Asia vary on their views about a market bubble. “What constitutes a bubble?” said one. “Unreasonable valuations and excessive speculative capital? I wouldn’t say I see evidence of that.”

But others disagreed. “I think there is a risk, certainly,” said Rogerio Bernardo, director on the bond syndicate desk at RBS, highlighting the risk of a change in the outlook for rates. “If US Treasury yields start to rise it will put a lot of pressure on fixed income funds and hurt a lot of portfolios. The bubble is certainly there and we could see a rapid shift away from fixed income assets if base rates are rising.”

A separate RBS report, authored by analyst Erik Lueth, argued last month that emerging market 10-year sovereign bonds were overvalued by 5% on average.

In a note to clients yesterday [May 3], Capital Economics assistant economist Paul Hollingsworth said he expected renewed pressure on dollar-denominated emerging market government bonds because they were vulnerable to a curbing of quantitative easing, concerns about valuations, and increasingly fragile outlooks for near-term economic growth in emerging markets. But he added: “Despite these three factors, we don’t expect any sell-off in dollar denominated EM bonds to be dramatic.”

The boom in debt issuance in Asia ought to be good for this problem, since there is a greater variety of assets for funds to go into, absorbing demand. But the dramatic increase in high yield issuance, particularly from Chinese real estate companies and sometimes with lesser covenants that used to be commonplace, may be problematic should there be a reversal in sentiment.