Emerging markets debt edgy before job numbers; Brazil revisits Lula scandal

By Reshmi Basu and Paul A. Harris

New York. Feb. 2 - Emerging markets debt was put on edge Thursday in a mixed session as Brazil dipped and Argentina soared, one day ahead of the release of non-farm payroll numbers in the United States.

"We were a little bit weaker today [Thursday]," remarked a trader.

"Nothing traded too much. I think people are getting their positions set before payrolls tomorrow [Friday]."

Meanwhile Brazilian bonds were dragged down on headlines that president Luiz Inacio Lula da Silva had prior knowledge of the bribes-for-votes scheme. In reaction, Brazil's local and external markets slid. The Bovespa lost 3%. And the trader noted that the country's external debt traded heavy at times as the news brought out sellers.

At the opening of the session, the Brazilian component of the EMBI+ index was tighter by five basis points. By the end, the country had widened by six basis points, according to a market source.

During the session, the Brazilian bond due 2040 lost 0.30 to 128.80 bid, 128.95 offered.

Argentina discount rallies

Elsewhere Argentina outperformed the asset class, according to market sources.

"The Argentina discounts in dollars were up a point and a half, after being up a point yesterday [Wednesday]," noted the trader.

"Argentina lagged this rally for a while and it is now playing catch-up," he added.

Furthermore, the market source said the discount bond was further helped by a technical short squeeze.

During the session, the Argentinean discount bond due 2033 gained 1½ points to 91¾ bid, 92¼ offered.

Overall, trading volumes were moderate with mixed players. However, Brazil did see local pressure on the Lula news, observed the trader.

Firm tone in Asia

Moving to Asia, the market is quite active in terms of flow and client activity, but trends are few and far between, according to a New York-based trader who focuses on the Asian fixed income markets

Asian trading is seeing constructive flows, he observed.

"We've seen primarily buying across the whole spectrum of Asian credits, and also support from the CDS [credit default swap] and synthetic markets," he said.

The firm tone in Asia is a function of technical strength as well as decent fundamentals for Asian credits.

"There is just an enormous amount of cash finding its way into asset markets. A lot of it is finding its way into fixed income, and into Asia, either directly or via synthetic structures. And it's providing a lot of support," noted the New York-based trader.

Nonetheless, supply out of the region has been scarce. It is normal for the pipeline to pause ahead of the lunar new year holidays. But Asia has been back for a couple of days now and there have still not been any new deal announcements or new issues.

"There is quite a lot of pent up demand for paper," he added.

Indonesia sees new highs

In the secondary market, Indonesia scored new highs and new tights across the curve, said the New York-based trader.

The Indonesian bond due 2035 was spotted at 111 1/8 bid, 111 7/8 offered, up a quarter from Wednesday, as well as from a week ago.

"But don't forget that a week ago Treasuries were a lot higher. So in spread terms the Indonesia 2035 is about 15 [basis points] tighter over the past week to 10 days," he commented.

Elsewhere, the Philippines has seen a bit more liquidity and has thus been a little more vulnerable to Treasuries, and to the recent small pullback in emerging markets.

"But Philippines has traded very well. In dollar terms we're not that far from the highs. In spread terms we've pulled back slightly today [Thursday] but we're still very close to all-time tights," remarked the trader.

Where's the values, asks investor

Many have noted that with spreads hovering around 200 basis points, the market is, indeed, overstretched, making it more difficult for investors to get more bang for the buck.

"I hardly know what to say. I can't imagine how anybody sees value in emerging market sovereign bonds," remarked Stephen Hope, managing partner of Outrider Management.

This month may see Brazil's foreign exchange reserves exceed external government debt. Hope notes that some market analysts may see this as a landmark event because in theory Brazil could service or buy back its foreign debt, thereby insulating the sovereign from overseas shocks.

Nonetheless Hope points out that at the end of 1996, the Thai central bank had $40 billion in foreign exchange reserves and an external government debt of $5 billion.

"And in 1997, we all remember that the Thai currency devalued by nearly 50%. And most of the corporate debt in Thailand defaulted," Hope noted.

"The sovereign in Brazil may be graduating in some way, but I don't really believe that passing that threshold is an accomplishment for the economy as a whole."

Hope does not criticize policymakers for their decisions. In fact, he said that they have done everything that they have been asked to do in the last three to four years. But he said he finds it odd that many are saying that Brazil has turned it around, after being at death's door just three to four years ago.

"I just don't think you are getting paid for the risk. It's not just Brazil. In fact, it's not particularly Brazil. You can easily go through and pick out individual countries and say, 'we really like the way they are managing their debt.' There are a lot of good individual stories out there," such as the Philippines, Brazil and Turkey.

"But a lot of the oil credits would not be good stories except for the fact that oil doubled in price in the last 18 months. If oil prices turn around, places such as Ecuador are going to have severe difficulty and market prices don't really reflect that."

Furthermore, Hope notes that commodity prices have to remain at these levels, for countries such as Brazil to service their debt.

Hungry for yield

The search for yield is credited for driving the market tighter. The expectation of solid flows has allowed the asset class to recently weather both equity and Treasury volatility.

"I think you have a lot of risk-seeking capital in the marketplace. You have a reduction in global risk premia. And I don't know when or if that will realign. It's definitely true - in my mind at least - that getting paid 2% a year for five years to insure the Philippines against default doesn't seem very attractive."

EM decouples from Treasuries

Also striking is how "irrelevant" U.S. Treasury levels have become for the asset class in the last several months, observed Hope. And that trend could easily extend into the next session, even as Treasury yields may potentially jump higher on the release of Friday's U.S. non-farm payroll data.

"The bullish case for buying emerging market debt stems from a weak dollar prognosis and the credit implications of these issuers, which doesn't have to do much with where Treasuries go.

"If the economy is growing fast and Treasuries weaken, that's good for Brazilian companies and therefore for the Brazil government as a credit."

"You could argue that a weakness in Treasuries should at this point perhaps strengthen emerging markets commodities-based debt. And that's kind of the way the market has been moving."

Even the U.S. equity tumble and reintroduction of political noise out of Brazil Thursday did little to derail the asset class. In late trading, the EMBI+ was two basis points wider over Treasuries, which Hope calls a "blip" given the context of the news in the last several months.

"It's an unusual day that emerging market debt doesn't tighten."

Hope guesses that the asset class will churn out low-to mid-single digits this year, "so it will be coupons minus a few percent for price declines."

He is monitoring the Iranian nuclear program as well as the avian flu story. Even though they have not so far impacted spreads, they could potentially become two of the most disruptive global events to impact the market. And like most, he is watching the election cycle.

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