The emerging market debt boom is about to fall apart

THESE are fairly tragic times for investors in developed world sovereign debt. Thanks to the combination of quantitative easing and a flight to (perceived) safety, bond yields have been pushed down to historic lows. Two year US Treasury notes issued on Monday yielded 0.63 per cent. Even 30-year notes are hardly doing much better, yielding 4.59 per cent. Perhaps as a result, and perhaps simply because these funds have drastically overperformed over the last decade, vast amounts of money poured into emerging market sovereign and corporate bond funds last year.

According to JPMorgan, net inflows into emerging market debt for 2010 added up to about $75bn. As a result, yields have been pushed down, with the spread between emerging market bonds yields and US Treasuries at its lowest level in years. Much of the developing world is currently suffering an explosion in inflation, however. Is it about time that investors stopped buying developing countries’ debt?

It certainly seems so. Geoff Blanning, who manages Schroder’s ISF emerging markets’ debt absolute return fund, has moved 40 per cent of the fund’s assets into cash – the maximum allowed. The rest is invested in very short duration, low risk bonds. Blanning argues that while it is still possible to make money in emerging markets, especially in the long run, bonds are currently far too popular.

“The best time to go into emerging market bonds was over 20 years ago, at the end of the Latin American debt crises,” says Blanning. But now, “in a passive way, there’s absolutely no way to make money in bonds”. “Yields are rising everywhere and there’s a high probability of capital losses”. Blanning argues that many emerging market governments, in particular Asian ones such as the Chinese, made a serious mistake by not raising interest rates earlier after the end of the global recession.

As those countries struggle to deal with high inflation, investor confidence will disappear, and bond prices will collapse. The yield on Indonesian 10 year bonds issued on 4 January has already increased from 7.17 per cent at issue to 8.90 per cent yesterday – implying around a 10 per cent loss in the value of the bond. Blanning argues that the best way to make money in bonds now is through a currency play – eventually, many Asian countries will be forced into revaluing their currencies to combat inflation, which will benefit bonds denominated in local currencies.

Indeed, some other large institutions have been nodding in agreement. The Bank of England recently warned in its financial stability report that too much money from the developed world flooding into emerging market debt could create bubbles and destabilise economies – leading to large losses. The World Bank’s quarterly East Asia update in October said much the same thing about East Asian economies in particular.

So what should investors keen to get access to emerging markets do? According to George Hoguet, a global investment strategist at State Street Global Advisors: “Unanticipated inflation is a big concern for a lot of investors… And though we think the secular case for bonds is still strong, now is very much not an optimal moment to invest”. He argues that long run investors shouldn’t completely dismiss bond funds, but they need to carefully check out what they’re investing in and weigh the timing. Some corporate bonds seem more attractive than sovereign bonds, for example. Hoguet also points out though they are much more volatile, emerging market equities are yielding around 8.5 per cent, and so might be a better investment.

But though it may not seem so in Britain at the moment, the developed world’s economies are recovering, while Asia’s and South America’s seem a little overheated. American GDP figures are out tomorrow and if they do not surprise in the way the British ones did, then interest rates and yields may start rising. In that case, investors might find it a reasonable time to start bringing their money back home.