beyondbrics

After the flight from emerging market equities and foreign exchange, comes a move out of EM local currency bonds.

With investors’ nerves breaking in the face of the bad news emanating from the US and the eurozone, some fund managers have started selling EM local currency bond holdings,  notably in Brazil, South Africa and Indonesia.

It’s only a trickle so far, but in today’s shell-shocked markets it could easily become a flood without some signs of light coming from the gloom hanging over Europe and North America. The bulls will be watching this weekend’s IMF/World Bank meeting. The bears don’t believe it will be worth the wait.

Local currency bonds have been the great beneficiaries of the torrents of cash pouring out of developed world central banks and looking for a return, in the form of higher yields and the prospect of currency appreciation.

When hopes of an early end to the Greek crisis and of a US recovery faded in the summer, investors first sold EM equities and then, in the last month, currencies. But they generally held on to their EM bonds, even when they hedged the currency risk.

In the last couple of days, they’ve started selling the bonds as well. Not massively, but selectively, choosing countries where they felt particularly exposed – those with volatile currencies and with big foreign participation in local currency bond markets – ie those where the first men out could hope to retreat with some dignity, but the last might find themselves stuck in the exits.

Bhanu Baweja, strategist at UBS, told beyondbrics that one trigger was the JP Morgan GBI EM index of global EM local currency bonds expressed in US dollar terms falling below par for the year. “With the index turning negative, expectations are adapting.”

Compared to the dramatic declines in currencies, the movements in bonds are modest. In the past month, the Brazilian real and the South African rand have fallen by over 18 per cent; the Polish zloty is down by 17 per cent and the South Korean won by 11 per cent.

A decline of around 6.6 per cent in the unhedged JP Morgan GBI EM index of EM local currency bonds is almost entirely explained by currency depreciation of EM fx against the US dollar. The GBI EM index of EM local currency bonds ignoring currency losses is down by only around 2 per cent (see charts).

But there are pockets of weakness. Brazil’s offshore real bonds – aimed at foreign investors – are down 18 basis points for the benchmark 10-year paper over the last two weeks. Mexican peso benchmark bonds were 18 basis points lower on Thursday;  South African equivalents slipped 12 basis points and Indonesian 15 basis points.

Zaheer Imran Ahmad of RBS says investors aren’t selling because of concerns about EMs and EM economic growth, but because of a wish to reduce risk globally.  “We have come to a point where if there’s no solution to the EU’s and US’s problems there will be contagion.”

But there’s no need to panic yet, insist the EM bond traders.  Edwin Gutierrez, EM debt manager at Aberdeen, the fund management group, says: “At the moment, there’s a good amount of long-term value in the market, but in the short-term we don’t feel any need to be in any hurry over it.”

The best hard data on whether investors are buying or selling (or sitting on the fence) comes with weekly figures from EPFR, the US agency that tracks funds. It’s next release late on Thursday will be widely watched.

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