Complacent about emerging market bonds?

Whilst the bull market in credit (especially high yield) has got all the headlines over the past few years, one bond asset class has been an even more spectacular performer – emerging market debt (EMD). In mid 2002 the yield premium over US Treasury bonds for the EMBI+ emerging market bond index was a massive 11%. Today it’s just 2% for an average credit quality somewhere around the BB or B level (ie junk).

You can justify this shrinking in risk premium in many ways – increased globalisation and extremely strong global GDP growth, higher global liquidity and demand for higher yield instruments, mispricing of the asset class following the Asian crisis, Russia and Argentinian defaults leaving EMD cheap. But I think we’ve gone too far, and that cracks are starting to show in the fundamentals for these emerging market government bonds. Last night the central bank of Thailand introduced exchange controls for international investors (the stock market was down nearly 20% at worst), and elsewhere we have seen growing unease at the regulatory and legal framework in Russia (how do you enforce property rights there?); fears about the growing influence of extreme left governments in Central America; a couple of military coups (Thailand and Fiji); and most worrying of all – the prospect of a global slowdown in 2007. EMD looks expensive given these risks – the term “priced for perfection” is overused by us, but is probably apt, unless you believe that these governments will never again renege on their obligations.