TO hear regulators tell it, traders should be up at night worrying about a crisis in emerging-market debt.
A sharp increase in US interest rates could threaten financial conditions in developing economies, Federal Reserve (the Fed) members said in meeting minutes released on Wednesday. The Financial Stability Oversight Council echoed this warning in a report released this week that said “a rise in yields in advanced economies could spark a sell-off in emerging-market bonds and destabilize markets.”
Traders aren’t listening, or else they’re not buying the argument. Instead, they’re buying debt, reaping returns of 9.2 percent this year on dollar-denominated junk bonds sold by emerging-market companies, more than twice the returns during the same period in 2014, according to a Bloomberg index.
Still, here’s the concern: Rising US rates should ostensibly cause the dollar to strengthen, making it harder for developing nations and their companies to repay the record amount of debt they’ve incurred in the past few years.
The dollar has gained almost 16 percent in the past 12 months against a group of its peers as the Fed prepares to raise rates as soon as this year.
“A world of both higher yields and a stronger dollar would pose a notable risk for emerging-market corporates,” Mohamed El-Erian, chief economic adviser for Allianz SE, wrote in an
e-mail. “If sustained, credit concerns would mount in the context of an EM corporate market that is not known for having deep liquidity during periods of instability.”
Issuance boom
In other words, once money starts flowing out of nations from Belize to the Philippines, it may be hard to get it to go back before bond investors suffer deep losses as borrowers become insolvent. El-Erian is also a columnist for Bloomberg View.
Companies in developing countries have sold record amounts of bonds since the 2008 crisis, locking in cheap financing costs as central banks pumped unprecedented stimulus into the global economy. Emerging-market nations and companies have issued $436 billion of debt this year on top of 2014’s record $1.3 trillion of issuance, according to data compiled by Bloomberg.
So far, investors don’t seem concerned. They’re demanding 6.6 percentage points more than government benchmarks to own dollar-denominated junk bonds from developing nations, down from about 10 percentage points in January, Bloomberg index data show.
Foreign reserves
There are some good reasons they aren’t losing their cool just yet. Emerging-market corporate issuers tend to generate much of their revenue from exports, giving them a steady stream of dollars that creates a natural hedge against currency devaluations, according to Barclays Plc. and Goldman Sachs Asset Management. And many of those who don’t have overseas revenue often buy currency hedges in the derivatives market to protect themselves, analysts at those banks said.
Meanwhile, developing nations have also stashed away more foreign reserves than they had historically, potentially buffering against big currency swings. Today that figure stands at $7.7 trillion.
While all of these details may give bond buyers comfort, they’re not enough to assuage the concerns of many—including Fed officials who are contemplating what their first-rate hike since 2006 will do to financial conditions in the developing world.