Prices gain as day progresses; Argentina better; Venezuela lower on bank struggle; Brazil firm on rate cut

By Paul Deckelman and Aaron Hochman-Zimmerman

New York, Sept. 6 - Emerging market bonds started Thursday's session in a treading-water mode, with investors continuing to worry about the state of the credit markets and uncertain about what to make of recent U.S. data - whether it would indicate that the American economy, the largest export market and main trading partner for many emerging countries, would be harmed by the fallout from the mortgage industry's troubles.

But sentiment seemed to brighten later in the day, as positive government and private data came out showing the U.S economy not as badly off as feared, which helped to spur U.S. and global equities - widely considered a proxy for more risky asset classes, a category which also includes high yield bonds and emerging markets paper.

Argentina's bonds were seen better, up for the first time this month, as investors apparently shrugged off concerns about the reliability of government inflation data, a concern which has negatively impacted the bonds since the beginning of the year.

Fellow high-beta credit Venezuela's bonds, however, were easier, as the market followed gyrations in overnight lending rates arising from the intensifying struggle between president Hugo Chavez and the governors of the traditionally autonomous central bank over just who will control that influential institution.

Brazil's bonds manage to eke out gains, helped by yet another cut in the country's benchmark lending rate.

Outside of the Latin sphere, Asian bonds remained pretty much range-bound, including the widely followed Philippines sovereign issues and related credit default swaps contracts.

Stocks up, Treasuries off, spreads narrow

Good economic news from the Labor Department, which reported that U.S. worker productivity rose at an annual 2.6% rate during the second quarter, the most in almost two years, combined with positive data from the private Institute for Supply Management, which said its index of non-manufacturing business activity held at 55.8, indicating sustained growth, helped to boost U.S. stocks. The S&P 500 and Nasdaq Composite indexes each posted modest gains on the session, while the bellwether Dow Jones Industrial Average added 57.88 points to end at 13,363.35. Stocks were also helped by better-than-expected August sales reports from major retailers.

That helped to push U.S. Treasuries lower, with two-year note yields up more than 6 basis points to 4.08%, and the 10-year note's yield up 4 bps to 4.51%, after having briefly touched their six-month low at 4.46%.

That rise in Treasury yields helped EM bonds to reduce their average spread over Treasuries, considered the key measure of investor tolerance of additional risk, or aversion to it. The widely followed EMBI+ index compiled by JP Morgan & Co. showed the average spread having narrowed by 5 bps to 228 bps.

Argentina leads the way

For the first time this month, Argentina's bonds were seen on the upside, gaining an average 0.5% in thin trade on the local market. Its Discount bond denominated in dollars gained 1.46% while the peso Discount bond rose 1.37 %, closing at ARS110.7 with its yield at 8.6%, lower than Wednesday's 8.67%. The Par bonds in peso also closed higher at ARS40.7, with its yield at 7.71%, down from 7.73% Wednesday.

Argentina's benchmark 8.28% dollar-denominated global bonds due 2033 were seen up about 2/3 point to end quoted at 84.5 bid.

Investors mulled over the news that Argentine inflation came in at 0.6% in August, a slightly higher inflation figure than had been expected, spurred by higher education, health and food costs. Some economists insisted that the "real " inflation rate was well above that figure, contending that president Nestor Kirchner's government was manipulating the numbers for political reasons, a charge Kirchner has repeatedly denied.

Brazil paper helped by rate cut

Brazil also reported an inflation rise, with consumer prices up 0.47% percent in August from the previous month, led by higher food costs. Even so, the central bank's monetary policy committee felt that inflation was sufficiently under control to reduce its key lending rate by 25 bps to 11.25%, as expected. It was the 18th cut since 2005, when that rate stood at 19.75%.

Even with the reduction, Brazil's interest rates remain the highest in South America, making its currency, the real, and bonds denominated in reais, attractive to investors.

The price on its benchmark zero-coupon real-denominated bonds due 2008 rose, while the bonds' yield fell 6 bps 10 11.15%.

Brazil's widely traded benchmark 11% dollar-denominated bonds due 2040 meantime were seen up 1/8 point to 132.125.

Venezuela bank problems cast a shadow

Venezuela's bonds however, were easier on the session. While its benchmark 9¼% bonds due 2027 managed to trim their early losses of as much as a point to end only moderately lower, quoted around 98.5, its 5¾% global bonds due 2016 were quoted as having eased to about 80.40 from 80.70, while that bond's yield rose by 7 bps to 9.11%.

Investors in Venezuelan paper watched with some concern developments in that country's banking procedures, including the roller-coaster gyrations of the key interbank overnight lending rate, which at one point on Thursday zoomed as high as 120% after the country's central bank said it would halt some of its lending operations to financial institutions, at the prodding of president Hugo Chavez as he tries to bring the traditionally independent Banco Central de Venezuela under the control of his government.

The lending rate came back down to around 30% by the close, but that was still up from the average 22% rate seen on Wednesday and way up from the 8.7% average daily rate seen at the beginning of August.

Chavez has been critical of the central bank's traditional autonomy, seeing it as an obstacle as he pursues his ambitious agenda of transforming the South American nation into a full-fledged socialist state. He has attacked the bank on the legal front, proposing constitutional changes that would bring it under the direct authority of the government, and financially as well, draining nearly $20 billion in foreign reserves from the bank over the past two years to finance his expansive program of government spending.

The fiery populist strongman earlier this week demanded that the central bank stop acting as "an oxygen tank" for banks needing cash, which in turn led it to suspend repurchase agreements that it has used at times to pump cash into the banking system. However, the central bank did declare that it would continue some lending operations, including remaining the lender of last resort.

Asian sector seen becalmed

A New York-based trader in Asian issues said that there hasn't been very much activity in his sphere of the market lately. "Volume-wise, it's been pretty light," he observed.

"If you look at where spreads are, where prices are, there hasn't been a lot of movement."

He said that over the last several weeks, "there's definitely been a bigger drop in liquidity," as some players eschewed the market entirely in view of the unsettled conditions.

Back from the end-of-summer holiday break earlier in the week, "some people came in, hoping there would be more activity and more movement." On Tuesday, he said, it was a good day for equities, causing the EM market to trade "a bit better," while Wednesday saw a reverse of that.

With things so up in the air, "trading is very short-term," with investors going in and then out again. "There certainly isn't any long-term trading".

New-issue-wise, he said "a couple of small deals have gotten done, "but they've been done pretty much through reverse inquiry from the would-be buyers to the potential issuers.

Big sovereigns, CDS dominate

Trading, he said "has been pretty much limited to CDS and a couple of sovereign cash issues. Among the latter, the widely traded Philippine government bonds "have done better over the last couple of sessions, though obviously lagging Treasuries." The long end of the curve, such as the 2031 and 2032 bonds, "is up maybe 3 or 4 points over the last two weeks. It's definitely lagging [Treasuries] in spread terms, though it's not trading that badly at all."

The cost of hedging against a possible default in those bonds via a credit default swaps contract has held in "a relatively tight range over the last week or so," hovering somewhere between 175 bps and 195 bps, well down from the mid-August wide levels around 250 bps, which coincided with the lows in the equity markets and the maximum market turmoil.

"We bounced off those wides pretty quickly," he noted, and then spent the next couple of weeks trading pretty much in that 175 bps/195 bps range. "So the spread volatility is definitely dropping off in these hedging issues," although those Philippine CDS spreads still remain well above the tight levels seen in June, inside of the psychologically potent 100 bps marker.

He said that only "the odd corporate issue with a price attached to it" was actually trading, at least in North America. In Asia, where he said the process is "a little bit more transparent," there was "quite a lot of price discovery going on" - but again, with "not necessarily" that much real dealings behind it.

Asia drifts

During the Asian trading day earlier Thursday, bonds were seen mostly drifting, with no definitive course, and little liquidity in the market. Weaker equity trading on exchanges in the Far East combined with the negative momentum fallout from Wednesday's emerging markets session in North America, when bonds fell and spreads widened on average by about 9 bps after U.S. stocks dropped on new data showing weakness in housing and employment, to keep Asian players at bay.

There was also a reluctance to take any strong positions, one way or another, before the scheduled Friday release of U.S. non-farm payroll growth numbers for August, which could reflect what effect, if any, the recent mortgage-industry credit crunch might have had on the overall economy.

The Philippine benchmark 2031 bonds were seen not much changed at 107 bid, 107.5 offered, and its 2032s were at 96 bid, 96.5 offered. The cost of a 5-year CDS contract widened out a little to 177 /183 bps from prior levels at 174 bps.

On the corporate front, Titan Petrochemicals Group's 2012 bonds were seen down a point at 87 bid, 88.5 offered, following a Moody's Investors Service downgrade of the Chinese oil tanker operator's credit ratings.

Quiet primary tests optimism

In the primary market another day without a new issue allowed some of the cracks to show in the façade of optimism which remains around the stagnant emerging market new issue arena.

Volatility, which is ever present on the minds of investors, slightly tempered itself during the day's session. The VIX index dropped 0.59 points to finish at 23.99.

Any gains which have been made in the last few days are not built to last as the credit crunch drags on, according to an emerging markets advisor.

"I don't think they understand what is really happening here," the emerging markets advisor said about those who are convinced the U.S. subprime crisis is all but over.

"It's different this time," the advisor said.

Investors must carefully examine the events leading up to and the actions taken to deal with the current crisis, the advisor said adding: "we all have to learn."

The advisor said he could see market sentiment "easily going the other way again" in the coming days and weeks.

The decisions by the European Central Bank to leave interest rates at 4% as well as the lack of movement on the primary side were not surprising, the advisor said.

"I'm really negative [about] the next two weeks," the advisor said.

The lack of leadership in the primary arena has left many corporations and governments unable to raise money. That has not yet severely damaged issuers in a significant way, but that time is coming.

"By the end of the month the hardship will be taking place," the advisor said.

If anxious issuers can overcome the stagnation expected until the end of September, then "constructive" progress may take hold, according to the advisor.

Asian corporates liquid enough to float

Asian credits are likely to survive the current credit crunch as most have enough secure financing to avoid throwing themselves on the mercy of the international bond market for the next year to 18 months, according to a market source.

In Asian credits, investment grade spreads are in general valued at a "fair" level, the market source said.

On the other hand, high yield spreads have been underperforming and are drifting towards being undervalued, the source added.

If there is a significant slowdown in the international bond market over the coming weeks, as the emerging markets advisor suggests, most Asian corporates are funded well enough through high coal and commodity prices to remain unaffected, the source said.

Property developers in China, especially the smaller and less liquid developers may be the most susceptible to a continuing set of difficulties for those attempting raise funds, the source added.

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