Nicholas Watson in Prague -
With a month of the year remaining, global bond funds are already well into record-setting territory with more than $400bn invested so far this year. But while emerging market bonds in general are expected to continue performing well next year, and pulling in more cash, the outlook for Emerging Europe bonds is more uncertain.
Emerging market sovereign debt has returned nearly 16% this year, corporate high yield almost 17%, and local currency bonds about 14%. bne's 2012 Fund Survey, published in August, showed just how well Central and Eastern Europe (CEE) bond funds had performed over the previous 12 months: the winner of the "bne Best Fixed-Income Fund 2012" was Erste Asset Management's "ESPA Bond Emerging Markets Corporate" fund with a return of 8.01% between July 1, 2011 and June 30, 2012. Compare that with winner of the equity category, which was Erste's "ESPA Stock Istanbul" fund with a negative return of 0.21%. Other bond funds also performed solidly, including Pioneer Investments' "PIA Central & Eastern Europe Bond" fund, which returned 9.2% in the first six months of 2012.
The reasons behind the EM bond rally aren't hard to pinpoint. Emerging markets' economic fundamentals are much stronger than those of developed markets - five-times faster growth, ten-times less debt, and control of 80% of the world's foreign exchange reserves. At the same time, their bonds were badly mispriced at the end of last year as investors (and the rating agencies) proved slow to realize the major changes in the global economy that the 2008 crisis and now the Eurozone crisis have wrought.
Capital inflows into emerging market bond funds have been growing since 2010, contributing to a fall in sovereign spreads across the board, but this trend has definitely picked up in the last 12 months as the Eurozone crisis deepened and the disparity widened between the slow-growth, debt-laden economies of the rich world and the healthy emerging market economies.
"Those that manage European bond funds are trying to reduce their exposure to countries like Italy and Spain - and the sheer size of their bond markets means that even a small movement out can wash into other European bonds," Mark Allen, the International Monetary Fund's (IMF) senior resident representative for CEE, told a conference in Prague organised by Wood & Co at the end of November. "Hungarian default swaps have fallen from 700 basis points (bp) to 250bp - that hardly reflects improved fundamentals, but does reflect the amount of money sloshing around."
There's been a consequent increase in bond issuance from Emerging European countries trying to take advantage of the lower rates. Poland has issued the equivalent of almost $12bn of foreign currency debt in 2012, with the latest coming at the end of November, which was a $750m reopening of 12-year euro-denominated notes priced at 135bp over mid-swaps, compared with the 143bp spread when it sold the original €1.75bn tranche just a month previously. Poland's total issuance trails only China's $30bn among emerging market peers, according to data compiled by Bloomberg.
Other sovereign issuers include Slovakia, Serbia and Slovenia, while the rally is tempting other, even more troubled, names such as Belarus, Ukraine and Hungary.
Russia has been a heavy local currency bond issuer this year as the government has been preparing to give foreign investors unfettered access to the country's sovereign and corporate ruble bond market by hooking up to the international settlement system Euroclear. That finally happened in November. VTB Capital predicts $50bn will flow into Russian bonds in just the first few months following the move. Currently, foreign investors account for about 4-5% of government and corporate bonds outstanding, well below the 15-20% held by foreigners in the bond markets of Russia's BRIC peers.
A harder year
The question for investors is where we go from here. Jan Dehn of Ashmore Investment Management, writing for the Financial Times' beyondbrics site, points out that the general trend of emerging market countries converging with richer countries remains intact and actually is still in its relative infancy.
Furthermore, even after this year's rally, emerging market fixed income is still cheap by historical standards. "Sovereign dollar bonds - on average an investment grade asset class - today trade at 280bp over US treasuries compared to 165bp prior to Lehman [Brothers' collapse]. Emerging market corporate high yield spreads offer even more value at 640bp over compared to 270bp before Lehman," Dehn writes.
Developed market bonds, he says, are trading at bubble levels; by contrast, conditions in emerging market debt are at the opposite end of the spectrum. "Today's emerging market investor is mainly local, institutional, and long-term oriented. Emerging markets are one of the few remaining sovereign bond markets without direct central bank manipulation of prices. External debt/GDP has declined steadily from 60% in the 1980s to 25% today, while it has increased to 250% in indebted developed nations over the same period," Dehn says. "A rapidly expanding yet still underfinanced corporate sector renders emerging market corporate bond supply extremely price elastic, constrained in effect by demand, which is growing only as fast as perceptions change about the asset class."
Yet while emerging market economies in Asia, the Middle East and North Africa, and South America are expected to continue growing solidly next year, the same can't be said of Emerging Europe.
The IMF's Allen predicts the Baltics should do best in the region in 2013, followed by non-EU Southeast Europe, Central Europe, then EU Southeast Europe - but all four areas are heading for a slowdown. "There could be a pick-up in the second half of the year, but that's predicated on things going right and uncertainty dissipating," he says.
The key events that need to go right are the US managing to piece together a deal to prevent "falling off the fiscal cliff"; Europe making further progress in sorting out the debt crisis; and emerging markets avoiding a hard landing of their economies. "I don't have a very encouraging story to tell - it depends on lots going right in the Eurozone," he said. "I can't see very bright spots, but the risks are less than before."
The problem that afflicts Emerging Europe more than other emerging market regions is of course its reliance on the rest of Europe and thus its proximity to the crisis. Miroslav Singer, governor of the Czech National Bank, told the same conference that the main risk to the region is an escalation of the crisis in the Eurozone: while he says he's optimistic, the issue is still a source of tension. "If we need to strengthen a bigger country like Italy, Europe must do it in a more efficient way or we're all doomed," he said. "Spending €150bn to sort out Greece's €200bn problem does not strike me as a very efficient way of managing a debt problem."
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