Emerging market debt softer; Brazil sees profit taking on Palocci rumors

By Reshmi Basu and Paul A. Harris

New York, March 17 - Emerging market debt was softer Friday on speculation that Brazilian finance minister Antonio Palocci would quit amid a brewing political scandal.

The Brazilian Social Democracy Party is calling for Palocci to resign because of charges that he frequented a house in Brasilia where former advisers would split cash from kickbacks and where prostitutes would also visit.

The finance minister has denied the allegations. And on Friday, president Luiz Inacio Lula da Silva publicly stated his support for Palocci.

Nonetheless, locals took some profits in order to protect themselves against any negative news that may surface over the weekend, according to a trader.

During the session, the Brazilian bond due 2040 shed 0.25 to 131.50 bid, 131.55 offered.

Brazil's election

Earlier in the week, the Brazilian Social Democracy Party (PSDB) picked Sao Paolo governor Geraldo Alckmin as its presidential nominee. Until now, Brazilian bonds had moved higher on news of the the market-friendly candidate.

The PSDB picked Alckmin over the more populist candidate, Sao Paulo's mayor Jose Serra, which was an unthinkable scenario a few months ago.

The only Brazilian corporate trading Friday was hydroelectric generation company AES Tiete SA, according to a Brazilian corporate analyst. He added that the market was more focused on Mexico, especially Satmex.

Despite the move towards local profit taking, prices were generally stable as the market was complacent regarding Alckmin as well as on strong signals from the central bank that interest rates will decline gradually, noted the analyst.

Lula moving to the left?

Investors are divided as to whether or not Lula will be forced to move to the left in the upcoming political season, potentially leading him to make market-unfriendly promises in his reelection bid. One source argued "no," given that Lula has already bedded the left.

"He doesn't have to appeal to those people because it's like when Bill Clinton was running for president. He doesn't have to worry about the left. He has those guys in his pocket."

Meanwhile the source expressed his surprise at Brazil's decision to reopen its bonds due 2037 (Ba3/BB/BB-) to add $500 million in a drive-by on Thursday.

The reopening priced at 103.747 plus accrued interest from Jan. 18. The issue came at a spread of 204 basis points more than Treasuries or a yield of 6.831%.

"They are going to have to call the Bradys. But I was under the impression that they were going to be more focused on local issuance than tapping 40-year debt," he noted.

Furthermore, it will interesting to see what happens when Brazil does call the bonds, which will change the composition of indexes. The buyside source said that his initial reaction was that investors, awash in new money, would redirect the cash into Brazil.

"Now you are changing the indexes, so I guess we're probably end up seeing how index-centric people are acting these days," he observed.

EM sees outflows

Another surprise this past week was the previously reported news that emerging market dedicated funds saw $153.43 million leave the asset class, according to EmergingPortfilio.com Fund Research.

This was the first time this year that the market posted outflows.

"There's plenty of cash sitting around. The last couple of weeks have been pretty volatile for emerging markets and the fund flows are going to act with a lag to that," remarked the buyside source.

Additionally, investors are overweight in emerging markets and are therefore more likely to be skittish than to buy on dips, he observed.

During the recent correction, core markets were also volatile. And then adding more to the fire, the Bank of Japan ended its ultra-loose monetary policy.

"Interest rates have gone up. It's obviously not the end of the world if they continue going up," the buyside source told Prospect News.

"But I think at the margin, the leverage trade has been squeezed significantly already," he said, adding that those trades will be squeezed even further on the actions by the European Central Bank and the Bank of Japan.

"I think the big losers...are banks because they are the biggest leverage players. I don't get the sense that the leverage bid is what's driving emerging markets," surmised the source.

Instead, the catalyst is real cash and that chase for yield.

Meanwhile the themes of tight spreads and the lack of value in the asset class continue to concern the investor.

"If you are buying emerging markets today, you really have to revise down your long-term return expectations," he said, adding that the market is trading less like high yield and more in sync with Treasuries.

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