26 January 2006

Demand for this week's issue reflects the positive sentiment continuing to play out in emerging market debt, writes Joanna Chung

To understand how big the appetite is for emerging market debt these days, one should look at what has been happening to prices of bonds newly issued by Iraq, a country that has suffered one of the worst economic and political upheavals in recent history.

Since the bonds started trading officially at the beginning of the week, prices have jumped from about 70 to a high of nearly 74 this week. Andrew Chappell, associate director at Exotix, the London-based broker, says: "We are still seeing a lot of demand chasing very little paper."

Prices receded to about 72 yesterday, translating to a yield of 8.95 per cent. That means investors currently perceive Iraq as having about the same credit risk as Jamaica, but as having less risk than both Ecuador and Argentina, say analysts, because the comparable bond yields on the latter two countries are higher than yields on Iraq's bond.

Such bullishness has been playing out among most emerging market bonds for three years. But there seems to be no end in sight for the rally, at least in the short term. Rising demand for higher-yielding emerging market bonds pushed up prices to new highs yesterday and sent the risk spread, as measured by JPMorgan's EMBI+ index, three basis points tighter to a fresh low of 219bp over US Treasuries.

Part of the recent rally has been helped by a continued sell-off in the US Treasury market. But Will Oswald, global head of emerging markets quantitative strategy at JPMorgan, says: "There are continued strong inflows from investors in Asia and the Middle East." The bank's latest client survey indicated there was about Dollars 1.9bn of strategic inflows in the first three weeks of this month and a pipeline of about Dollars 1bn in the near term.

Over the years, investors have been increasingly drawn to the emerging markets, which have experienced a dramatic improvement in creditworthiness. Most countries have stronger economic fundamentals, including rising foreign exchange reserves, stronger export growth and current account surpluses that have been helped by rising commodity prices. David Riley, managing director at Fitch Ratings, says up to50 per cent of the tightening in spreads is due to an improvement in fundamentals.

But the appetite for risk has also been growing. The CBOE Vix, the volatility index which measures market expectations for volatility and appetite for risk, is at historic lows; a decline in volatility is closely correlated with an increase in risk appetite (see chart).

Jerome Booth, head of research at Ashmore Investment Management, an emerging markets specialist, notes in a monthly report that there is a greater appreciation for the medium and long-term diversification benefits of emerging debt.

Moreover, he adds that more and more pension funds that have unfunded liabilities "are shedding their prejudices about emerging debt" and accepting the strategic argument for including them in their fixed income portfolios, though it may take time to increase allocation.

There are concerns down the road. As Mr Riley of Fitch Ratings explains, emerging market countries have become one of the great beneficiaries of the global imbalance which has most of them running current account surpluses while the US has a current account deficit.

"There could be a lot of unwinding when there is a correction to global imbalances," he says. "At some point along the line, the US must cut its deficit and then the emerging markets will see their surpluses decline and their external positions worsen."

For the moment, however, investor interest in the wider asset class as well as individual credits is unlikely to go away. Iraq, for instance, faces huge challenges, including the completion of political transition and economic rehabilitation. But it has also enormous long-term economic potential and its bonds are backed by the world's third largest oil reserves.

Mehmet Simsek, strategist at Merrill Lynch, also points out that demand for Iraq's paper is likely to be strong, if only because of its expected inclusion in various EM benchmark indices. The Iraqi bond, which has a face value of Dollars 2.7bn, is set to enter JPMorgan's EMBI Global index by the end of March and is likely to be included in other indices.

But Jim Croft, emerging markets trader at Commerzbank, warns: "The overall feeling is one of extreme bullishness, but there is a risk of consolidation given the extent and speed of the rally."

By Joanna Chung