Emerging market debt firmer; Brazil 2040 hits 105

By Reshmi Basu and Paul A. Harris

New York, Aug. 20 - Emerging market debt was firmer Friday even while U.S. Treasury prices fell as oil recoiled from its record highs.

Spreads on Latin American sovereigns tightened as Brazil ascended towards new highs, despite the lethargic tone in the U.S. Treasury market, according to a market source.

"There's a good tone to the market,' said a trader.

"But it's August - tough to tell if it stays this way when everyone comes back from vacation," he added.

An emerging market analyst agreed that August's strong performance might not carry into September.

"I think it's difficult to say anything conclusive about the market right now given the lack of liquidity.

"EM has been essentially ignoring high oil prices for some time now, just using low U.S. interest rates to put carry trades back on," noted the emerging market analyst.

"That's helping Brazil, Venezuela, Ecuador, etc., but nobody has any good idea of what happens when the August vacations are over and issuers start to tap the market again.

"New supply will put some upward pressure on spreads come September, but if 10-year U.S. rates can remain around 4.20% the search for yield should keep this market relatively well bid for a while," he added.

In trading Friday Mexico's bond due 2026 added 0.35 to 147.65. Venezuela's bond due 2027 was up a point at 92½ bid. And the Ecuador bond due 2030 rose 1.1 to 78.10 bid.

Overall, the JP Morgan EMBI+ Index rose 0.42%. Its spread to Treasuries tightened 11 basis points to 439 basis points.

Brazil hits 105 handle

Meanwhile, the headline story belonged to Brazil. The country's strong fundamentals are pushing the credit towards new highs. Its bond due 2040 hit the 105 handle in late morning trading, while the C-bond reached the 97 handle.

"Brazil 101/4s due 2013 were trading at 104.5 a couple of days ago," said Diane Keefe, portfolio manager for Pax World High Yield Fund.

"We're hearing that the Brazilian economy is booming. The New York Times reports that Brazil's retail sales are up.

"It's not only the export side of their economy, such as steel, but also their consumer economy is going almost as strong as China.

"I think furniture and electrical appliances were up 10% year-over-year. And shoes and clothing were also up, in the high double digits.

"Brazilians are spending, and that is obviously good for the economy.

"The problem with emerging markets, historically, is that they have been so volatile that they have scared off more people than high yield has.

"And people are generally more comfortable investing in their own country than they are going elsewhere.

"If you have a period of strong stability then on the margin that fear will decline.

"Brazil is one of the key countries. If it continues to stabilize and improve I would suspect that you will see more money going there. The international banks have been there for decades, even through the crises," she noted.

For the day, the Brazil C bond added 0.625 to 97.125 bid while its spread tightened 21 basis points to 522 basis points. The bond due 2040 was up 1.4 to finish the day right at 105 bid.

No stopping the carry trade

The carry trade is alive and well as leverage has crept back into emerging markets over the past six weeks, according to a debt strategist. Only a string of economic data, which rekindles concerns about global growth re-acceleration, could possibly reverse the carry trade.

"I think a series of economic data releases that suggests that the Fed will have to become more rather than less aggressive about the pace of their tightening would produce something similar to what we saw in late April and early May in both the level of Treasury yields as well as in people's commitment to spread products, including high yield and including emerging markets," said the debt strategist.

"And it's going to be conditioned by the data."

The consensus forecast is that the market has priced in a couple more Fed tightenings this year for a rate of about 2% at the end of the year.

"The bias in the data has been that the world economy is slower than people had expected, not faster.

"And people will continue to look for confirmation of that slowdown. And so long as they see that, they are not going to be to worry about policy shock surprises.

"It doesn't feel like 1994 to most investors," he added, referring to the last sequence of rate rises that came so sharply that they devastated the bond market.

Brazil's domestic rally?

Furthermore, Brazil appears to be the one credit able to withstand shocks, given that its corporates are resisting panic mode, according to the debt strategist.

"I think what people are grappling with is the fact that the one that is well positioned is Brazil. And Brazil is sort of resilient to bears," he added.

"Brazil is more bear proof than it certainly has been in its past, ever.

Brazil garners its strength from its trade surplus numbers, which empowers its corporates.

"When people freak out and sell off, the corporates don't have to hedge.

"Why? Because they are printing huge trade surplus numbers, so they are rolling in hard currency.

"When people try to push the Brazil currency down, it doesn't stay down. It pops like a cork," said the strategist.

"The market scares itself to death over headline X or Y, and then they short it.

But this time, corporates don't see a panic hedge decision because the currency is not overvalued coupled with the looming trade surplus.

"That means they have all kind of dollars around. And so the dollar repatriation creates the bid for the real, and their markets don't get going," he said.

However, before talking about a Brazil upgrade in response to the change in solvency, several factors must be considered, such as whether inflation has kicked in in Brazil.

And if inflation is on the rise, will it permit Brazil's Central Bank to resume easing rates?

"If that's the case, if the domestic inflation expectations start pointing down instead of up, will there be a duration panic and will people start trying to buy longer maturity domestic securities?"

And that could ignite a big domestic rally, he observed.

Some may question whether Brazil is capable of a domestic pick up, but it has happened in other countries.

"We saw it in Mexico. We saw it in South Africa. Certainly in Thailand when interest rates fell to 1%," he noted.

For this to happen, there must be a rise in local savings and a sustained current account surplus.

"Brazil has always struggled with its local saving but for the moment the current account is doing alright," he told Prospect News.

"The real threat to the story, which would be a nirvana story for domestic bondholders, is the low saving pool and the concern that as soon as Brazil starts to grow rapidly again the current account will widen as import demand increases.

"There's still controversy about the Brazilian outlook. But for the moment, we have some tests and the exchange rate has been very well behaved.

"And the real difference is that corporates don't panic now. They don't have to because they are awash in dollars," he observed.

Fund flows seen as support signal

The emerging market bond fund flow data released late Thursday continue a trend that certainly suggests a more supportive scenario than that which has prevailed during the past few months, with the less volatile four-week moving average of fund flows finding its way back into the black for the first time since April.

EmergingPortfolio.com Fund Research reported an inflow of $43.5 million in the most recent week, the second consecutive week of inflows. The number is based on 200 emerging market bond funds with total assets of $16.5 billion. The inflow was a fairly modest one, down from the previous week's $76 million and well short of $200 million-plus weeks seen in January and March, a market source told Prospect News.

The source added that the data tends to reflect retail inflows, with a fraction of the more strategic institutional mandates showing up in the weekly figures.

Meanwhile, the source added, international debt funds that can invest in both emerging and developed country bonds reported net inflows for the 10th week in the last 12, taking in a fairly modest $145 million.

On the other hand, high-yield funds underwent their fourth consecutive week of outflows, although only a small loss this time, with AMG Data Services reporting that the asset class lost a meager $26 million.

Latin American corporates flat

For the most part, Latin American corporates were flat during Friday's session. There were a few movers.

Mexican steelmaker Altos Hornos de Mexico SA de CV's paper due 2004 was up three quarters of a point to 26½ bid, 28 offered.

Argentine hydroelectric power co. IMPSA bond due 2011 was up a half a point to 37 bid, 38 offered.

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