EM meltdown proves blessing for some

Fri Feb 7, 2014 2:54pm EST

NEW YORK, Feb 7 (IFR) - Issuers jumped back into the investment grade market this week and global asset managers went on the hunt for cheap emerging market corporate bonds, as issuers and investors pounced on unexpected opportunities that have arisen because of the EM currency meltdown.

In stark contrast to the consensus view at the beginning of this year, the 10-year Treasury yield has rallied from over 3.00% to 2.66%, as investors fled emerging markets and then unexpectedly weak US economic data further frayed nerves and sent equities plunging.

"The year started with a very strong consensus that stocks would go higher, growth would be stronger and rates would go higher," said Ashish Shah, global head of fixed income investment at AllianceBernstein.

"But what happened is that the economic data disappointed and emerging markets sold off. That started a much stronger rally in Treasuries than what people were positioned for."

Few in the industry expected the investment-grade corporate bond market to end January as the best-performing asset class other than Treasuries. Nor were asset managers expecting strong inflows into investment-grade funds.

But in the week ending February 5, Lipper reported an outflow of USD972m from high-yield funds, a USD20.905bn outflow from all equity funds and an USD2.21bn inflow into investment-grade funds.

In the year-to-date, high-grade bond funds have seen USD10.8bn of inflows in a year when the "great rotation" into stocks was expected to put pressure on the asset class. More than USD6bn, meanwhile, fled EM equity funds in the last week of January, according to EPFR.

The result has been a quick recovery in high-grade corporate bond spreads that had blown out in the last fortnight. And by Thursday, jumbo trades had returned to the new issue market too, with IBM issuing USD4.5bn on orders of USD9bn and Deutsche Bank USD3.5bn on books of USD6.5bn.

Although new-issue premiums were still slightly elevated (IBM paid about 8bp on its five-year tranche and 7bp on its 10-year) companies with smaller-sized trades pushed premiums down to almost nothing.

WADING IN

Savvy institutional investors are, meanwhile, wading into muddied emerging market waters in search of blue-chip high-grade emerging market bonds that gapped out along with the rest of EM.

"This is a classic emerging market correction. We've seen dozens of these in our careers and it always ends as a buying opportunity," said Michael Collins, senior portfolio manager at Prudential.

"Ultimately, long term, the best returns in fixed income will be from emerging market debt."

Shah also sees value in EM corporates arising from the recent market selloff, saying: "The dislocation has been relatively broad-based and more a function of some of volatility in currencies ... so we are very selectively identifying high-quality investment grade EM companies that are trading at yields that are more comparable with high-yield than high-grade."

Shah is particularly interested in Latin American companies that are likely to benefit from developed market growth and are not exposed to local currency volatility or developing economies like China.

"This is a classic emerging market correction. We've seen dozens of these in our careers and it always ends as a buying opportunity".

That includes high-profile names such as Pemex, all the way down to Mexican REITS.

Collins also likes names such as Pemex, as well as companies and quasi-sovereigns from countries including Mexico, South Korea and Taiwan, which are not dependent on China.

Korea Gas Corp was a beneficiary on Thursday of the hunt for EM corporates. It attracted a book of almost USD4bn for a 10-year deal that was capped at USD500m.

BARGAIN HUNTING

It also is not hard to find the bargains. There are obvious choices, such as Pemex, which trades around 200bp over Treasuries in the intermediate part of the curve - some four times wider than ConocoPhilips.

"There is a whole slew of EM corporates that look cheap to similarly rated and similar quality US corporates, whether investment-grade or high-yield, and if you are selective you can pick up a lot of incremental spread for not a lot of extra credit risk," said Collins.

Although markets can turn on a dime, especially this year with so much uncertainty around the impact that Fed tapering will have on EM as well as the strength of the US economy, there is a long-term underpinning of demand for the asset class from US pension funds.

"Pension funds want to be globally diversified and right now their allocation to EM is less than the representation of EM in global GDP and less than the representation of EM in global bond indices. So by any measure they are under-allocated," said Aziz Sunderji, emerging market corporate credit strategist at Barclays.

"Retail investors are leaving the asset class but pensions funds will be adding to their allocations, particularly when valuations compared with developed markets are so compelling."

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