Article / 25 May 2016 at 10:25 GMT

Weekly Bond Update: Fed fear a hair in the soup for EM bonds

Fixed Income trader / Saxo Bank
  • Rebounding commodity prices, sinking intererest rates have fed EM optimism 
  • Argentina's comeback to international bond markets met with overwhelming demand
  • Brazil's Petrobras successfully returned to bond markets after one-year pause
  • Russia defies US and EU sanctions with oversubscribed new 10-year USD issue
  • New-found EM optimism could be challenged by agressive US monetary policy
  • EM bond issuers can cope with gradual US rate hike trajectory
Soup bowl
 A hawkish Fed could be a hair in the soup for emerging-markets bond issuers. Photo: iStock

By Michael Boye

Contrary to the negative sentiment in developed markets so far this year, optimism has been bubbling up across emerging markets, and recently lifted further by a rebound in commodity prices as well as sinking interest rates, particularly in the US.

Beyond keeping financing costs low for borrowers, the low-yield environment has also seen yield-starved investors up the ante in search of satisfactory returns and display a healthy appetite for new exotic bond issuers. However, the fresh outbreak of "Fed fear" — that is the fear of dramatically rising US interest rates — could quickly sour this new-found optimism.

As previously reported, Argentina found overwhelming demand for its comeback to international bond markets last month, and last week saw Latin America's largest private company, Petrobras, return to the bond markets after a one-year pause during which it has been the epicenter of Brazil's raging economic and political crisis.

Petrobras issued $6.75 billion of new 5-year and 10-year USD-denominated bonds priced at yields of 8.6% and 9.0%, taking advantage of the change in investor sentiment since the impeachment trial of suspended president Dilma Rousseff. The previous benchmark 10-year bond for the troubled oil producer, the 2024 bond, had already seen an improvement in yield terms from a 13% January high all the way back below 8% earlier this month. With total debt standing at $126 billion, the plate is full for recently appointed CEO Pedro Parente, a former energy minister, to turn around the company's financials, and he is likely to depend on a further improvement in oil prices to suceed.

Brazilian and Russian credit default swap prices indicate improved credit conditions

Source: Bloomberg

This week another emerging-market sovereign completed an unexpected comeback to international bond markets, as Russia defied two-year old sanctions from US and EU lawmakers prohibiting capital market access

With US and European banks strongly warned about participating in the deal, and as a further consequence no eligibility in Euroclear or Clearstream settlement systems (effectively requiring any participating investor to keep the bonds in domestic Russian custody), the Russian government still managed to draw interest of more than $7 billion. The deal was eventually set at $1.75 billion and priced at 4.75% yield, marking a significant rebound from the 8% yield that Russia's existing 10-year bonds reached in secondary trading a year ago.

While the foreign capital will certainly plug a hole for Russia's heavily oil-dependent economy struggling to cope with a runway budget deficit, the symbolic aspects of the bond issue are perhaps the biggest win for the Kremlin. Proving that the detested international sanctions won't be able to cut off acces to international funding goes a long way to support President Vladimir Putin's efforts to downplay the domestic impact of his policies in Ukraine. Furthermore, capital markets could find comfort in so far as the refinancing risk of other major bond issuers in Russia could be greatly reduced going forward.

Looking ahead, however, this new-found optimism across emerging markets could be severely challenged by agressive monetary policy in the US, which has lifted its head in financial markets for the past week. Amid continued vocal guidance from several members of the Federal Open Market Committee, the likelihood of a rate hike in June has been priced up to 34% from a slim 4% just a week ago. In conflict with our most recent call of a potentially hesitant approach towards the end of the year, the market now sees as much as a 78% chance of a rate hike by December. 

This has cooled interest in foreign emerging-markets debt for now, and while an aggressive US rate hike path certainly poses a threat, we think the Federal Reserve will be wary of igniting a new debt crisis and that a gradual slow-paced rate hike trajectory is both well grounded in the markets and something emerging-markets bond issuers can cope with as well.

Map of Brazil and South America
 Optimism has swept across emerging markets, as shown by successful bond 
issues in Brazil and Argentina. Image: iStock

— Edited by John Acher

Michael Boye is a fixed income trader at Saxo Bank


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