market folly

Emerging Market Debt

By Robert P. Smith

Led by explosive economic growth and rising commodity prices, emerging market debt has climbed out of the dark corners of the global economy and into the spotlight. Countries such as Brazil, which once conjured the specter of default and runaway inflation, now lend money to the International Monetary Fund. Russia, whose default and devaluation in 1998 helped trigger the Long Term Capital Management crisis, has foreign reserves of US$ 434 billion and is expected to return successfully to the bond markets next year. Though a few countries, such as Argentina and Ecuador, remain in the shadows, the long term outlook for emerging market sovereign debt is much more stable than it has been historically.

When I began dealing in emerging market debt (EMD) in the 1970s, it was a tributary of a backwater. Few investors conceived of opportunities in Turkey – “the sick man of Europe” – or in war-torn El Salvador. I traded my first EM debt instruments by placing want ads in local newspapers, and I repatriated my capital via black-market money-changers.

Now it’s possible to buy EMD via ETFs and derivatives on major stock exchanges. Investors worldwide have gone on a shopping spree that has pushed the JP Morgan EMBI Total Return Index, which measures the price of hard currency EMD, to record levels.

Of course, there have been major improvements to justify the optimism. Brazil, for instance, a country that used to stumble from crisis to crisis, has weathered the global economic storm admirably. This country that once experienced inflation of almost 2500% was one of the first to emerge from recession. Surging demand for commodities and raw materials from China has helped national champions like Vale and Petrobras soar. More importantly, perhaps, President Lula has defied initial expectations that he would follow in the footsteps of Venezuelan President Chavez, adhering instead to the liberal, responsible policies of his predecessor Cardoso, which focused on fighting inflation.

However, huge financial stimulus packages and 0% interest rates in developed nations have created a “wall of money” effect; billions of dollars seeking returns have flooded emerging markets, compressing yields in countries often regarded as basket-cases. There is no comparison, of course, to my early days in the EMD market; back then, low confidence in countries like Russia and Brazil meant that you could pick up their sovereign debt at a huge discount. Current investors in Russian or Brazilian bonds could lose money if the US decides to raise rates and some of that liquidity drains out of emerging markets. There is less of a concern that these governments, now sitting on sizable foreign reserves, will default on their debts anytime in the foreseeable future.

Now that the world has cottoned on to the opportunity, it’s a lot harder to make a killing. Sovereign EM yield spreads over US Treasuries have slimmed down to about 300 basis points, a far cry from the 700 bp spreads of eight months ago at the recent bottom of the market. Since then, emerging market sovereigns have issued $72 billion in bonds, according to Dealogic, an international analytical firm. Investors should ask themselves if improved conditions justify these valuations, or whether bubbles are forming in global markets. I believe value is scarce in this environment. Perhaps it may only be found hiding in a few dark corners.

Robert P. Smith is the founder and managing director of the Boston-based Turan Corporation. A noted authority on emerging market debt, he is the author of RICHES AMONG THE RUINS: Adventures in the Dark Corners of the Global Economy. Visit www.richesamongtheruins.com for more information.