ANALYSIS-Emerging bond sales, returns face US yield hurdle

Thu Mar 29, 2012 2:34pm BST

* Higher US yields may drive up EM borrowing costs

* EM first quarter issuance $114bln; almost half of 2012 total

* Rising dollar a headwind for local FX debt

By Sujata Rao

LONDON, March 29 (Reuters) - Emerging market borrowers may have to hurry to secure cheap funding on global debt markets as rising U.S. yields push up costs and hit anticipated returns on emerging debt.

Treasury bond yields and the dollar have risen in recent weeks on signs of an economic upturn which many fear might rule out further money printing by the Federal Reserve or even shake its resolve to hold interest rates at rock-bottom until 2014.

A 30 basis point rise from their January lows in 10-year bond yields US10YT=RR, the underlying risk-free rate for assessing emerging valuations, has stalled a roaring early-2012 rally in emerging equities and currencies. That is because higher Treasury yields reduce the premium investors receive to own emerging assets.

Hard-currency EM debt has so far weathered the shift better than other asset classes, but the risk is that borrowing costs will rise sharply as new bond prices for emerging sovereigns and companies are typically benchmarked off Treasuries.

"Where we are in the Fed cycle it makes huge sense for issuers to come as soon as they can," said Jeremy Brewin, a fund manager at Aviva Investors in London.

"Even if they've missed the perfect moment by 20-30 bps it doesn't matter, because by the end of this year most of the financing done today is going to look cheap."

Bond sales could total $600-$800 million a week in coming weeks, he reckons, as borrowers try to lock in low yields.

Russia opted this week to increase its first dollar debt sale since 2010 to $7 billion from a targeted $3.5-$5 billion, completing its 2012 foreign borrowing plan in one fell swoop.

Emerging governments have already sold bonds worth $32.5 billion this year, data from Bank of America/Merrill Lynch shows, a 58 percent jump from the same period in 2011. Sales including corporate bonds total $114 billion, or almost half the $246 billion the bank expects to see issued in 2012 as a whole. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

FACTBOX on emerging Q1 debt issuance [ID:L6E8ES927]

GRAPHIC on 2012 asset returns link.reuters.com/muc46s ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Emerging issuers have enjoyed a two-fold benefit from the U.S. money-printing programme. Low yields have enabled them to borrow at relatively cheap outright prices - Mexico for example raised 30-year cash in January at a cost of just 4.84 percent.

Meanwhile, the huge amounts of liquidity slurping through world markets have boosted demand for emerging assets, compressing the spread between emerging and U.S. yields.

Recent dovish comments from Fed boss Ben Bernanke knocked U.S. yields lower but most do not expect the decline to last. Reuters polls forecast 10-year U.S. yields at 2.4 percent by September from 2.2 percent now and at 2.7 percent by March 2013.

"There’s a lot of apprehension about the U.S. yield curve," said Zsolt Papp, who helps manage 1.2 billion euros in emerging debt at Swiss bank UBP in Zurich. "Bernanke’s tone is one thing, but people are looking at the data, which shows U.S. economic recovery is reasonably well entrenched."

The losers may be countries such as Hungary and Ukraine which haven't started 2012 issuance and must raise almost $10 billion between them. Emerging European sovereigns still need to raise around $20 billion, far more than Asia and Latin America.

THREAT TO RETURNS

Many view the change calmly. They note that the yield rise is gradual and it is driven by an upturn in the U.S. economy which usually bodes well for emerging assets.

Emerging hard currency bonds have in fact withstood recent market turbulence, with prices staying rock-solid. Yield spreads over Treasuries have compressed by around 90 basis points since the start of the year.

But these tight spreads make it tough to cope with a further Treasury selloff, especially for high-grade credits. Brazil or Mexico, for instance, offer a small premium of 75-100 bps over 10-year Treasuries, meagre protection against rising yields.

Brewin notes the investment-grade part of JP Morgan's EMBIG emerging bond index offers a yield just 200 bps over Treasuries.

"EM doesn’t have a huge cushion to shield it," he said. "We are at the level of, or around 10 bps off, a reality check"

JPMorgan this week halved its overweight on emerging sovereigns, betting the spread rally is nearing its end, and advised clients to reduce Brazilian and Mexican bond holdings.

The bank expects EM dollar debt to return around 8 percent this year if U.S. yields stay at 2.5 percent. But gains will shrink to 4.5 percent if they hit 3 percent, it predicts.

WORSE FOR LOCAL DEBT

A general rise in yields from historic lows seen during the financial crises of the last few years could be even more problematic for debt in emerging currencies such as Polish zloty and South African rand. Such bonds have found increasing favour in recent years as they offer high yields and exposure to strengthening emerging currencies.

While it may be hard to be very pessimistic on emerging markets if U.S. growth is improving, the emerging local debt boom of the past decade has happened in an environment of steadily falling U.S. yields and a weak dollar.

Now the sector faces a double whammy. Local debt tends to fare poorly when the dollar is rising, while a U.S. growth recovery may fuel EM inflation and push up interest rates.

Local debt has returned 8 percent so far in 2012, but investors are turning cautious, citing currency worries.

"You’ll be fighting the stronger dollar," said David Hauner, head of EEMEA economics and fixed income strategy at BofA/ML Global Research. "If there's no quantitative easing, why should the dollar continue to depreciate? That means the case for emerging markets will be less attractive."

(Additional reporting by Carolyn Cohn; Graphic by Scott Barber; Editing by Catherine Evans)

((sujata.rao@thomsonreuters.com)(44 20 7542 6176)(Reuters Messaging: sujata.rao.thomsonreuters.com@thomsonreuters.net)) Keywords: EMERGING DEBT/TREASURIES

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