Emerging debt rally at risk from rising Treasury yields

LONDON (Reuters) - Uncertainty over the timing of U.S. monetary stimulus and a rise in U.S. Treasury yields is threatening the blistering summer rally in emerging market bonds.

Some investors are being tempted to book profits from the record-busting run, which has made emerging debt among the best-performing asset classes of 2012.

Returns have been around 10-12 percent this year, courtesy of investors seeking refuge from zero- or negative-yielding developed market securities. Many bonds, especially local currency ones, are at multi-year or even all-time highs.

Some of this is now in danger. Yields have been rising on 10-year Treasury bonds, the underlying risk-fee rate that defines the attractiveness of emerging assets. The higher the Treasury yield, the less premium investors get from holding emerging assets.

The debate over whether and when the Federal Reserve will start buying more bonds in a third quantitative easing program - a move that would lower Treasury yields and make emerging debt even more attractive - is also making investors cautious.

Improving economic data may push the Fed to delay.

Analysts at JP Morgan have tried to calculate the impact of continuing U.S. Treasury rises.

The bank's main dollar bond index, the EMBI Global, has returned around 12 percent so far this year and could add another 3 percent if U.S. yields stay at 1.5 percent, the analysts said.

But returns for the rest of this year would halve if U.S. 10-year yields rose to 1.75 percent and would fall to zero if they jumped to 2 percent, the bank said.

The yield was 1.68 percent on Thursday but they hit three-month highs over 1.83 percent earlier in the week, a rise of almost 50 bps from the start of August.

All this has some investors shifting their emerging debt portfolios.

"Clearly the recent rise in yields reflects better-than-expected U.S. data," said Claudia Calich, head of emerging markets at Invesco which has $2 billion in EM debt.

She has raised her cash levels and favors debt issued by countries such as Angola which is less correlated with global developments than mainstream markets such as Brazil.

Calich does not view August U.S. yield rise as a game changer but reckons it is time to take "selective profits" on emerging markets, especially as governments and companies are likely to start issuing bonds again in September when the new issue market typically re-opens after a summer lull.

Rob Drijkoningen, who oversees $12 billion in emerging debt at ING Investment Management, has also become more cautious, particularly as he sees little chance of Fed QE near-term.

He is especially wary about on dollar debt from investment grade-rated markets such as Brazil and Russia which offer a relatively small premium over Treasuries.

"You have high-yield names such as Argentina and Venezuela which are trading close to 1000 bps (over U.S. Treasuries) and won't be materially affected by a 25 (basis point) rise in U.S. yields," he said. "But investment-grade has tightened to an extent we don't think the risk-reward is justified."

Brazilian dollar bonds listed on JP Morgan's EMBI Global dollar bond index carry a premium of 1.67 percentage points over U.S. Treasuries. That's down from 2.23 percentage points at the start of the year.

NO PANIC

So far despite some position-trimming there has been nothing approaching a big selloff in emerging debt. Data tracker EPFR reported continued inflows in August to bond funds.

And although 10-year Treasury yields have risen in August, they are still not far off record lows.

Dollar debt in particular has been solid, with yield spreads over Treasuries staying at one-year lows, meaning the overall index has actually outperformed the underlying "safe" asset.

However, yields on the main local debt index, JP Morgan's GBI-EM, have risen to 5.8 percent, around 10 bps higher than a month ago - a pointer to what may happen if Treasury yields firm.

What happens next will be crucial, with investors waiting to see if U.S. Fed boss Ben Bernanke drops any hints about QE in his speech next week at the Jackson Hole central bankers' get-together.

(Editing by Jeremy Gaunt.)

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Source: http://www.cnbc.com/id/48763964?__source=RSS*tag*&par=RSS

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