Emerging market debt outperforms as U.S. Treasuries gain; ICICI Bank prices

By Reshmi Basu and Paul A. Harris

New York, Aug. 13 - Spreads for emerging market paper tightened Friday as U.S. Treasuries made gains on news that producer prices fell short of expectations.

"It's all about the [Treasuries] curve," said a trader.

Treasuries got a boost Friday from the producer price data which showed an increase of 0.1% in July, below expectations. The core rate, which excludes food and energy, also gained 0.1%.

Emerging market paper was up. The JP Morgan EMBI Index rose 0.54% during Friday's session. Its spread to Treasuries tightened eight basis points to 451 basis points.

Oil-producing credits such as Ecuador, Venezuela, Mexico and Peru were all up.

Ecuador's component of the EMBI was up 1.23%. Its spread to Treasuries tightened 17 basis points to 829 basis points.

For the day, Brazil was also up. The C bond added 0.562 to 95.875 bid and its spread tightened 11 basis points to 559 basis points. The bond due 2040 up 1.1 to 102.10 bid.

Brazil's component of the EMBI was up 0.96%. Its spread to Treasuries tightened 21 basis points to 558 basis points.

In primary action Friday, India's ICICI Bank Ltd. priced $300 million bonds due 2009 at 99.468 to yield Treasuries plus 168 basis points via ABN Amro, Bank of America and Deutsche Bank.

Emerging market paper follows curve

Currently the low yields on U.S. Treasuries are holding down emerging markets yields but the outlook for Federal Reserve policy means prices on both need to go lower, according to Steve M. Hope, managing partner of Outrider Management. Hope's position is negative duration in Brazil and higher beta names.

Currently, inflation is low and is not expected to rise dramatically over the next five to 10 years, according to Hope.

"And on the flip side, you've got this tremendously accommodating Fed policy, which probably should be unwound, regardless of how strong or weak the recovery has been in the second quarter.

"We have a Fed policy that is geared more to an economy that has zero growth. And that needs to be changed," said Hope.

Most likely, core inflation is not going to move outside of the 2% to 3% or at most the 1½% to 3½% range in the next several years, added Hope.

"Are 10-years [Treasuries] mispriced at 4¼%? I think so, just because if Fed funds move to 2½%, you are not necessarily getting paid enough at 175 basis points over funds.

"My basic feeling is that the U.S. Treasury curve needs to reprice itself because the short end of it is artificially low.

"Having said that, I think it's hard to be really excited about U.S. economic growth prospects over the next several years.

"All of that is a backdrop for saying, what is there to love about emerging market debt at the moment?

"Anything below double digit yields, I don't care about," Hope told Prospect News.

Even credits such as Brazil are associated with lingering default risk, which makes one question whether or not it makes sense to own the Brazil bond due 2040 above par.

"Even if there's declining default risk, if 30-year Treasuries move from 5% to 6%, do you really want to own something that yields 11% and has Brazilian default risk attached," asked Outrider's Hope.

"Ecuador '12 can be called at par - they're within 3½ points of that now.

"Where is the upside? Are you really getting paid for the risk you are taking?

"If there's a downside of 30 to 40 points, let's say, in Brazilian bonds, how much upside is there? 10 points? 15 points?

"You are writing a big option to take the extra spread."

Looking ahead, the resulting shape of the yield curve is the driving factor for emerging market debt prices, Hope said.

"We live in a world now where emerging market issuers, by and large, are spread-based issuers - not issuers particularly trading on their own fundamentals, which are generally good.

"And that improvement in fiscal fundamentals is why they have graduated to this stage where they are spread-based products," added Hope.

Furthermore, Treasury prices are as vital as country headlines.

"The impact on the Brazil '40s from the Treasury curve is every bit as large as the impact on the bonds from domestic events within Brazil," said Hope.

Oil demand at $45

Oil prices jumped Friday to a new record above $46 a barrel, but yet there is demand at these prices, according to Hope.

"If we have a $10 terrorism premium built into the price of oil right now then that means demand is artificially higher than it should be normally at this price, said Hope.

"But the end consumer isn't consuming gas now because they won't be able to consume gas later.

"People are buying oil against the risk of disruption.

"So why did inventories drop in the latest release? How would that have happened if we have a $10 premium built in for terrorism?

"Now, short-run supply and demand is relatively inflexible in oil.

"It's a legitimate argument you can make, that we are $10 higher than where we would like to be. But the reality is that in at least the short run, the demand is still there at $45 per barrel.

"It's not the case that the price rise has created some slack by reducing the demand for oil in the short term," Hope told Prospect News.

Durango, creditors on same page

Corporacion Durango SA, Mexico's largest paper maker, announced Friday it reached an agreement with 68% of its unsecured creditors. The company hopes to go through the concorso mercantil process under Mexican bankruptcy.

Unsecured creditors will receive about 85% of their original principal amount in new debt and the remaining part in equity.

"It doesn't seem as good as the original proposal that was out about five months ago," said a market source.

"In the prior proposal they addressed PDI [past due interest], whereas in this one I don't see any mention of PDI, although the company says they are going to file a 6-K with the SEC.

"I haven't seen this trade in over a week.

"One other thing that is interesting is that the 2003 bonds, which they had defaulted on ahead of time, are being treated in the same manner as all the other outstanding bonds. In the first proposal the 2003 bonds were subordinated."

Venezuela up, despite recall

Heading into a recall referendum on President Hugo Chavez's rule over the weekend, Venezuela paper was up during Friday's session. Its component of the EMBI was up 0.22%. Its spread to Treasuries tightened five basis points to 561 basis points.

"The markets want a clear winner," said the trader. "Not a close vote."

However, the polls have Chavez in a dead heat to keep his job.

"Thanks to oil revenues, Chavez has been spending money like crazy.

"A lot of the polls have it pretty close. I saw one that showed 47% of the voters would recall him, and 43% would keep him. They seem to be crossing around the halfway mark.

"So it's really going to come down to the wire," said the market source.

According to the Venezuelan constitution, for the president to be recalled the Yes votes must outnumber the No vote and the Yes vote must be higher than the number of votes obtained by Chavez in the 2000 general election, which was 3.757 million.

If Chavez loses, an election will be held within 30 days. Thus far, the Supreme Court has not stated whether Chavez could participate as a candidate.

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