Emerging market debt retraces losses on GM and Ford news; Philippines to retap

By Reshmi Basu and Paul A. Harris

New York, May 5 - Emerging market debt was jolted by Standard & Poor's decision to downgrade both General Motors Corp. and Ford Motor Co. to junk - but eventually retraced some losses once the news was digested.

In the primary market, the Republic of the Philippines is expected to come with an add-on bond deal tapping either or both the 8 7/8% dollar-denominated bond due March 2015 and the 9½% dollar-denominated bond due February 2030, according to a source.

"The long end of the Philippines market is now up to the highs from the March of Destruction [March 2005]," said a trader.

"We just took out 110 bid, which was a pretty important resistance level in Philippines bonds due 2025.

"Valuations are noticeably higher. And there is chatter that the Republic of the Philippines is going to be doing a deal here pretty shortly.

"Both the 2015 and 2030 are good candidates. The RoP has never re-tapped a deal more than twice. The 2030 just came, and has never been re-tapped, and it is trading right around par. There is a pretty strong Street short in it. They could take advantage of that," he observed.

EM retraces losses

In the early afternoon, the S&P cut its corporate credit ratings on GM and Ford to speculative-grade.

The headline impact was immediately felt, according to a debt strategist.

He noted that prior to the GM announcement, the Brazil bond due 2040 was bid at 115.60. After the news broke out, the bond fell a full point to 114.60 bid, but eventually it erased some losses.

"The liquid long emerging market bonds...the Brazil '40 fell a full point and now we've retraced," he observed.

"We thought about that for a full 30 for 40 minutes, and we've retraced about half of the damage."

"At the moment, we are rallying," said the strategist in mid-afternoon. "But the headline event was a full point sell-off."

"The market had a shift of sentiment midway through the afternoon," said Enrique Alvarez, Latin America debt strategist for think tank IDEAglobal.

"Early on, we seemed to have been steady to slightly better overall - on lack of news and [U.S.] Treasuries sturdiness. But once the GM and Ford news came out, we started to drift lower," he continued.

Alvarez said that investors "sold short as soon as the news hit the market - trying to see if there was going to be an overly large reaction on the U.S. high-yield side.

"There doesn't seem to be anything over-stressful, but it still depends on what will happen on the U.S. side," he remarked.

"But as far as we are concerned, we saw bounce backs. I suspect that people sold immediately on the news, but when they did not see a panicked reaction, they covered.

"The market is going to end on the downside in Brazil. But I think that's the most significant part because Treasuries in the U.S. have advanced," he said.

By the end of the day, debt prices had erased some losses during Thursday's session. In late morning, the Russia bond due 2030 was spotted at 1073/4. After news of the downgrade, the bond had been spotted at 107.062 bid. At session's end, the bond was up 3/8 of a point on the day at 107¼ bid. In late morning, the Brazil C bond was spotted at 101½ bid. In mid-afternoon, the bond was quoted at 100 ¾ bid. The bond closed at 101 bid, up 1/8 of a point on the session.

Nonetheless, the trader warned that emerging markets is threatened by many external factors, and was surprised by how well the market held up.

"The tranquility at the surface belies how nefarious the undercurrent is. Prices are barely changed on the day," he said.

"But you can just sense that the backdrop is unsettled at best, and poised for a breakdown, at worst.

"It doesn't feel good. I am surprised prices have held in as well as they have.

"It won't take much to knock this thing down."

An emerging market analyst said that the downgrades were already priced in, as evidenced by the Brazil 2040s having retraced most of their losses in the late afternoon.

"But this GM/Ford story is not over yet, and, as we saw in the WorldCom and Enron episodes, these downgrades can really snowball," he said.

"GM & Ford are a different situation, of course, but, for the time being, EM will remain skittish about whether there is another shoe to drop from the U.S. auto sector."

Flight to quality fears

U.S. Treasury prices rose, making gains on a flight to quality from corporate bonds. At the end of the day, the yield on the 10-year note stood at 4.16%, improved from Wednesday's 4.19%. Prior to the downgrade news, the yield had touched 4.212%.

Previously, emerging market debt suffered when GM announced its profit warning, raising concerns that more investors would turn to the safe haven Treasury market.

The debt strategist said there are two schools of thought on what the downgrades mean to emerging markets.

"One has focused on a general kind of drip, drip, drip of bad news on various credits that is leading to increases in debt risk aversion - which is clearly a negative for emerging markets," he noted.

He said the second school of thought deals with the phenomenon of displacement.

"And here, people are thinking of high-yield funds and crossover funds.

"And if you drop GM out of the investment-grade space into the high-yield space, it will have to be held at some price.

"And that could push other things out of portfolios. And one of those things that could be pushed out...is single and double B emerging market names," he remarked.

"When you see this downgrade, you get people reacting in a sort of instantaneous reaction to both the risk aversion concern and then the displacement technical."

The strategist said that both have the potential to drive down emerging market prices.

Implications of 30-year Treasury

Meanwhile, the market was also considering the impact of a possible return of the 30-year U.S. Treasury. On Wednesday, the Treasury said it might bring back the 30-year bond.

"The only implication is that a lot of guys that had been short 30-year paper in emerging markets, like the Philippines or Mexico. Guys who had hedged it with the most recently issued 30-year Treasury, as opposed an older one, got crushed yesterday [Wednesday] because the bond fell disproportionate to the rest of the curve," said the trader.

"There were a lot of guys who were short: they were short credit, prices don't change yesterday [Wednesday], they were long this technically rich instrument that gets damaged because of the announcement from the Treasury."

Looking ahead, Friday's job numbers

The debt strategist said that the automaker downgrades do not raise the significance of Friday's non-farm payroll numbers given that one is a "quality dimension" and the other is a "duration dimension."

"The [job] numbers are very important, regardless. This doesn't make them less or more important. But a clear macro story that the market is grappling with at pricing is to what degree we are seeing a broad-based economic slowdown.

"Weaker car sales may be part of that, probably part of the Ford and GM story. Weakness in Germany and Japan is part of the story," he said

He commented that if the non-farm payroll numbers are soft, people will say that the soft patches are spreading. A strong figure would serve as a detail to support the view that the broad U.S. recovery is still reasonably intact.

"That's a huge story for 10-year benchmark Treasuries and for the S&P 500, and then by implication it's going to condition risk preferences for emerging markets.

"But it's more of the risk aversion part of the story for EM debt pricing that is about the displacement part. It has no affect on technicals, but it does have effect world-wide risk tolerance," he pointed out.

Real money hasn't left, says strategist

Not that much real money has left the market, according to the debt strategist.

"We've seen relatively limited spread widening from year-to-date compared to the kind of movements that we saw last May.

"There are still a number of bonds which I think are vulnerable to sentiment that has not sold off that much at all.

He cited the Brazil bond due 2040, which is trading at a 115 handle. The low of the year was 109 to 110 bid.

"In that 110 to 120 range, we are right smack in the middle," he observed.

"There's plenty of room to argue that there is more spread widening ahead of us but there's also room to argue that we are not as nearly tight as the beginning of the year.

"Both of those are accurate statements," remarked the strategist.

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