EM resumes retreat as risk aversion holds sway; high-beta Latin America underperforming U.S. high yield

By Paul Deckelman and Aaron Hochman-Zimmerman

New York, June 29 - Any hope that flickered on Thursday when the Fed decided to let it ride with respect to short-term interest rates seemed to be extinguished on Friday as emerging markets debt resumed its widening ways.

Risk aversion among emerging markets investors particularly hit Latin American high-beta names such as Venezuela, Argentina and Ecuador, while higher-quality paper, such as the sovereign debt of Peru, Panama, Mexico might be positioned for better performance.

EMBI wider by 10 bps

In the secondary market Friday, early gains on the back of Thursday's improved session and benign U.S. inflation data faded away and bond prices fell as spreads widened out on continued market nervousness about whether investors will want to keep dabbling in risky areas, such as emerging debt.

As the second quarter and the year's first half came to a close, the problems of the sub-prime lending market in the United States and the effects these have had on hedge funds and other market participants remained a sword of Damocles hanging over the heads of investors, who have recently pared their riskier holdings in a "flight to safety" reaction.

U.S. Treasury benchmark 10-year yields fell to 5.03% in late trading Friday, down a good 8 or 9 basis points from their levels on Thursday, buoyed by government figures showing Americans spent less than anticipated in May, with the rise in core inflation - prices excluding volatile food and fuel costs - reaching its slowest pace in three years.

All of that seems to point in the direction of inflation remaining under control, negating the need for further rate hikes by the Federal Reserve.

Despite that good news from a fixed-income perspective, emerging bonds generally were in retreat, unable to sustain the gains seen late Wednesday and on Thursday, which themselves were a rebound after lower prices - on pretty much the same fears - earlier in the week.

The widely followed EMBI+ index of emerging market performance widened out 10 bps to 175 bps - well above the all-time tight levels around 150 bps which the index had seen around the beginning of June, which occurred as the EM market possibly got ahead of itself.

"You have to visualize it under the specter of a market that was evidently excessive as far as yield-constriction is concerned," according to Enrique Alzarez, head Latin American debt strategist for IDEAglobal, an international research firm. "We've widened about 25 basis points from that."

Whether that risk spread continues to widen, he said, "is very dependent on the availability of credit across U.S. financial markets - whether there's a constriction there - and the level of losses that can be incurred in U.S. credit derivatives. The larger the losses there, the more the necessity that hedge funds are going to have to reach across categories and liquidate other positions. That may not mean that they're going to liquidate profitable positions - just any positions whatsoever."

He said that this scenario will produce "a cross-market risk that the emerging markets are going to have to deal with over the coming month or two months - it's not going to be easy in any sense, at least in my view."

As for how high the EM spreads, as measured by the EMBI+ gauge, may widen, "I think that from an investor psychological standpoint, 200 bps is probably the first objective that you have to think about. You would probably think that if it goes out to there, things would be re-assessed again. At least for the meantime, the market is very suspect," the analyst added.

High-beta Latin America weak

And it was the usual suspects leading the market downward on Friday, with Venezuela - whose debt is also being roiled by investor reaction to the government's recent takeover of several big joint venture oil projects and the withdrawal from those projects of international oil majors ExxonMobil Corp. and ConocoPhillips - among the key laggards.

Caracas' benchmark 9¼% dollar-denominated bonds due 2027, after having risen solidly on Thursday, bouncing back from Wednesday's losses - more than gave back those gains, falling 1¼ points to around the 104.25 level on Friday. The bonds' yield was seen having widened about a dozen basis points to the 8.80% region.

Ecuador was even worse, its 10% dollar notes due 2030 seen down a full 3 points on the session to 81, while its yield ballooned out nearly half a percentage point, spiking above 12.50%.

The volatile bonds of high-beta credits Venezuela, Ecuador and Argentina - each facing its own particular country-specific problems that worry its creditors - have badly underperformed the emerging markets sphere as a whole, which on a year-to-date basis is actually still showing a 0.7% gain, with six months now in the books, putting the asset class well ahead of U.S. Treasuries, down abut 0.8%, but well behind high yield, which has about a 3% return at the year's half-way mark.

Despite the ink which the dramatic problems of those three countries that are troubling bond investors have gotten - Venezuela with mercurial President Hugo Chavez grabbing control of large portions of the nation's economy in his push for socialism, Ecuador with the ongoing threat that it may choose to default on some or much of its $11 billion of foreign debt, which the country's new leadership calls "corrupt" and "illegal," and Argentina with investors highly skeptical of official economic data, believing that Buenos Aires has cooked the books for political reasons - there are still standout performers in the asset class.

In Latin America, Alvarez sees "a very clear differentiation" between what he called "the terrible trio - the continuous underperformers" and better performers such as Uruguay, "which still has some very good year-to-date gains, and I think that is also a credit that could be a potential target for some very reasonable profit-taking."

Among the low-beta, i.e., low volatility, names, Alvarez sees them "holding in better." In this group, he would put Peru, Panama, Mexico - depending upon what U.S. Treasuries do, of course - and Chile.

He opines that "I don't see a flight to lower beta overall," meaning a shift out of the treacherously risky high-beta credits into the more stable issues. "What the market is doing has been basically an artifice, short-selling Venezuela and Argentina, in that order, and Ecuador, to guard whatever profits are built in."

China mulls massive issuance

The People's Republic of China has plans for a local currency issue of 1.55 trillion yuan, the equivalent of $200 billion.

The deal will consist of phased issues, all with maturities of 10 years or more. The government intends to offload currency reserves to a state-owned investment vehicle.

"The ministry of finance will issue the debt to the central bank to buy a portion of China's $1.2 trillion foreign-exchange reserves and establish a new asset-management company," the ministry said on its website.

"The central bank will then sell the debt into the market to gradually drain cash from the economy," the website said.

Edenor brings new offer

Argentina's Empresa Distribuidora y Comercializadora Norte SA (Edenor) announced plans to issue up to $250 million in 10-year bonds (B).

The energy distribution firm will likely use proceeds from the sale to refinance existing debt.

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