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| Erik Lueth, Senior Asia Economist, RBS |
Investors have had a ferocious appetite for emerging market local-currency bonds since the outbreak of the global financial crisis, with yields falling 2 percentage points since mid-2007. Some have been attracted by the sounder debt metrics compared with mature economies. Central banks and sovereign wealth funds, in particular, have used emerging market bonds to reduce their huge exposures to dollar-denominated debt.
Others have sought higher returns from yields that were on average 300 basis points higher than those on equivalent US Treasury yields during January 2007 to March 2013, according to Bloomberg.
This demand has not been matched with unlimited supply because emerging market government bond sales are restricted by economic factors. At the end of 2012, the outstanding stock of emerging market local-currency bonds was $5.6 trillion, less than half of the $12 trillion debt stock in Japan and only a third of the $16.5 trillion bond pool in the US, according to Bank of International Settlements.
Yields on ten-year emerging market bonds have fallen sharply, by 1 percentage point in the past year to an average 4.7 per cent and down from 6.8 per cent in mid 2007, according to Bloomberg data. This is due to falling US debt yields, which create cross-border arbitrage opportunities and cuts to emerging-market policy rates.
In emerging Europe and Latin America, average yields have dropped even more than the global average, to 4.2 per cent and 6.4 per cent respectively. Emerging Asia debt today sports lower yields than several advanced European economies, with yields dropping to 3.4 per cent, compared to 4.3 per cent in Italy and 4.7 per cent in Spain, Bloomberg data shows.
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While weak global economic prospects and loose monetary conditions are rightfully positive for emerging market bond prices, and in turn have pushed down yields, the rally seems to have gone too far. Our analysis of the economic factors that generally determine 10-year emerging market debt yields against the actual yields from January 2007 to March 2013 suggests that emerging market bonds are in fact fairly valued. It shows actual yields have moved broadly in line with those predicted by our estimated economic relationship.
This analysis involved breaking down bond yields into the contributions of inflation, monetary stance, fiscal position, global yields, and global stress. We found these factors explained 90 per cent of yield variation over time based on a regression study between January 2007 and March 2013.
However, we believe this analysis is somewhat flawed because the estimation, like any estimation, is designed to minimise the gap between actual and predicted bond yields and therefore has a bias towards finding fairly-valued bonds.
To avoid this bias, we ran an out-of-sample forecast using data only up to March 2012. By this measure, emerging market yields are 0.6 percentage points too low, which suggests ten-year bonds are overvalued by about 5 per cent.
In the event of a sell-off triggered by the US monetary tightening moving closer, losses on emerging market debt could in fact be much higher than 5 per cent.
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Bonds look particularly overvalued in emerging Europe, where average yields are about 2 percentage points lower than in Latin America, where they are 4.5 per cent, despite the two regions having broadly similar economic fundamentals. In addition, yields in emerging Europe are 80 basis points lower than we would expect based on our out-of-sample analysis of economic factors against bond yields. Latin American bonds, with yields at an average 6.7 per cent, still look attractive to us because our fundamental analysis suggests yields of 5.2 per cent.
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In Asia, Indian bonds have the highest yields among emerging markets at about 8 per cent, which seems justified by the country performing poorly on nearly every economic measure. Public debt and the deficit amount to 67 per cent and 5 per cent of gross domestic product respectively, compared to 44 per cent and 0.8 per cent for the rest of the region. Inflation expectations are 8.8 per cent versus 3.4 per cent for the rest of Asia and at 7.5 per cent the policy rate is exceptionally high. Indian bonds therefore look fairly priced.
Indonesian debt, yielding 5.6 per cent, appears to be undervalued with overall economic fundamentals, in particular debt to gross domestic product and expected deficit, outperforming those of Thailand and Malaysia, where bond yields are about 210 basis points lower. Taiwan also looks overpriced, with ten-year bonds at 1.3 per cent. Economic fundamentals are broadly in line with Korea’s, yet yields are 140 basis points lower, our out-of-sample study shows.
With all things considered, based on our analysis, we expect to see a sell-off in emerging market bonds in the not-too-distant future. Analysing the overvaluation of the debt and any wider impact is an important exercise for investors and issuers to consider now.
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