Emerging market debt poises a threat amid rising US real yields

Bonds
Althea Spinozzi

Fixed Income Strategist

Summary:  Emerging market debt is showing signs of distress as US Treasury yields are rising. On Tuesday, Indonesia local currency bond issuance lacked demand for the full size. Yesterday, the country's central bank cut interest rates amid concerns that inflation is low and the recovery slow. Despite continuous sign of stress coming from the EM world, EM US dollar bond yields continue to fall even in light of US Treasury yields rising. We believe that EM bonds will not be able to continue to stand rises in US Treasury real yields and that they are poised to reprice.


Even though the market is focused on US Treasury yields rising, global bonds are selling off too. European sovereign yields have been rising on average five basis points a day . At the same time, emerging market debt both in hard and local currency has started to widen slightly. Although the selloff is not alarming yet, there is something significant happening: emerging markets are having difficulties in issuing debt. Tuesday, Indonesia was able to place only 30 trillion rupiahs ($2.5 billion) of local currency debt out of the 35 trillion rupiahs that the country initially planned to issue. It happened as US Treasury yields were rising  –which proved the market might feel some indigestion from risky assets as the selloff in Treasuries intensifies.

There is something in this story that deserves attention: Indonesia hard currency debt in US dollar is still offering the lowest yield in ten years and continues to fall while local currency debt has started to widen since the beginning of the year. This discrepancy is worrying because the positive correlation that there is between Indonesian local and USD dollar debt will need to be restored, and the one to suffer the most from the correction will be holders of hard currency debt.

Source: Bloomberg.

The rally of emerging market debt is a trend that we are seeing across all the emerging markets and that is starting to concern us as it looks like real US rates had hit a bottom and they are likely to rise. Rising real rates is a negative for risky assets such as emerging markets.

Source: Bloomberg.

Currently, investors buying into the Emerging markets are looking to build a buffer against rising rates in the US. However, it is necessary to have a clear investment horizon because if it necessary to sell these securities before maturity, the loss could be considerable.

In the mid-term, local currency EM bonds might be a better investment as their performance is tightly correlated to their FX component. The ideal environment for EM currencies to strengthen would be when the US economy is expanding. The reflation trade sees the economy growing faster than expected, sending commodity prices higher together with inflation, making it a perfect storm for bond values. However, in this environment interest rate differentials move in favour of emerging markets as local currency advances.

Another factor to keep in mind is that the value of hard currency emerging market bonds is more volatile than local currency peers. Below you will find Bloomberg Barclays emerging sovereign market index for local and hard currency debt. As you can see, in times of high volatility USD EM bonds is more volatile. This is mainly due to the fact that local currency debt doesn’t need to adjust much in light of the exposure it has to local FX rates. This is a buffer that USD EM debt lacks, making it more volatile.

As a conclusion, investors should reconsider holding emerging market bonds starting from US dollar EM notes. Even though USD emerging market debt can provide a much-needed buffer against rising inflation, it poses a serious capital loss threat in light of current historic low yields and rising US real rates. A that point, the only way to avoid big losses would be the one of holding the bonds until maturity.

Source: Bloomberg.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide and Product Disclosure Statement to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as CFDs and Margin FX products may result in your losses surpassing your initial deposits. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.
Please click here to view our full disclaimer.