RPT-INVESTMENT FOCUS-Investors pick dollar debt for emerging market re-entry

Mon May 5, 2014 3:00am EDT

(Repeats story that ran on Friday, with no changes)

By Natsuko Waki

LONDON May 2 (Reuters) - Investors dipping their toes back into emerging markets are choosing hard currency debt which, thanks to rich yields and expectations for a stronger dollar, is the developing world's best performing asset class this year.

The Institute of International Finance, which provides the most authoritative capital flows data, says emerging markets drew $25 billion from global stock and bond investors in April, after combined $55 billion inflows in February and March.

Bonds attracted almost two-thirds of April flows, IIF said.

Separately, Boston-based EPFR Global, which tracks mutual funds, says emerging bond funds had net inflows of about $500 million in the week to April 30, enjoying the fifth straight weeks of inflows.

But not all emerging debt fared well - dollar-denominated hard currency bonds attracted almost $300 million, but those in local emerging currencies such as the South African rand and the Turkish lira saw outflows again, reflecting investors' concern about currency weakness.

"People are not willing to take a high-beta fixed income view in terms of exposure to (local) FX where most of the volatility is. So there's more of a focus on dollar carry," said Fredrik Nerbrand, global head of asset allocation at HSBC.

"It doesn't mean we want to necessarily buy all EM credit - I suggest higher grade than lower grade. But valuation buffers in EM are sufficient in relative terms to offset high headline risks."

Hard currency debt is the top performing emerging market asset this year, rising more than 5 percent to beat both emerging and developed equities as well as most high-grade and junk bonds in developed markets.

Dollar-denominated bonds give investors a uniquely high interest rate without the risk of local currency volatility. And appreciation in the dollar adds to returns.

Local currency debt has only gained 2.8 percent this year in dollar terms. (link.reuters.com/pat75v)

Banks estimate there is a historically high 100-125 basis points pick-up in yield for those buying emerging sovereign debt, compared with Western corporates with comparable ratings.

"You get paid over 1 percent for owning equivalently rated sovereigns in EM compared with U.S. corporates. Investors are becoming more enthused about emerging markets," said Richard House, head of emerging market fixed income at Standard Life.

Correlations between emerging market credit spreads and U.S. Treasury yields have turned negative, having been positive between February and early April. (link.reuters.com/qyk98v)

This suggests investors are relatively more comfortable with the effects of the U.S. Federal Reserve's stimulus withdrawal, a factor that triggered a hefty sell-off earlier this year.

"The spread pickup available for switching from U.S. or Western European credit into emerging market credit remains at a historic high," Barclays Capital said in a note to clients.

"We believe nascent stability and better developments in the second half should encourage crossover investors to accelerate the buying in EM that is already underway."

Emerging market sovereigns and corporates have already successfully issued about $160 billion in new bonds this year, reflecting a strong appetite from yield-hungry investors.

And they are ahead of schedule - corporate issuance is almost half and sovereign bond sales are already halfway to full-year forecast volumes, JP Morgan says.

"EM external debt issuance tells more about inflows to emerging markets than mutual fund flows, as the latter covers a small fraction of total assets," Bank of America Merrill Lynch said in a note to clients.

"We see significant demand in our new issues from crossover investors who are buying these assets for a core holding, not for the purposes of selling them when they rally after they are issued."

Emerging market debt could get further inflows soon. Japan's public pension fund, the world's biggest with assets of $1.26 trillion, is seeking managers to buy emerging bonds as it tries to diversify from low-yielding domestic debt. (Additional reporting by Carolyn Cohn and Sujata Rao; Editing by Susan Fenton)