Emerging Debt-Down but market 'resilient' despite war fear

reuters.com Mon March 10, 2003 01:18 PM ET By Hugh Bronstein

NEW YORK, March 10 (Reuters) - Emerging market bond prices fell on Monday as investors grew jittery about the threat of a U.S.-led war against Iraq, but analysts said the market was holding onto an impressive chunk of its recent gains despite the geopolitical angst.

"It's surprising that we're not weaker than we are," one trader said. "Emerging markets continue to be resilient."

Brazilian bonds lost more than one percentage point, according to total returns measured by JP Morgan's Emerging Markets Bond Index Plus. But the dip still left Brazilian total returns more than 15 percent higher so far this year.

The index as a whole fell 0.32 percent, after rising more than 7 percent since Jan. 1.

Following an early-year rally driven in part by Wall Street's approval of the policies articulated by Brazil's new government, many analysts expected investors to flee risky emerging market assets as the United States set the stage for a war against Iraq that could depress global economic activity.

"But that appears to have been offset by inflows into the asset class," said Matt Ryan, an emerging markets portfolio Manager at MFS Investment Management, based in Boston.

As global stock markets wobble, he added, "We've seen allocations from equities into fixed income, and within fixed income there's a demand for the higher yields that are offered by emerging market bonds."

Emerging market bond spreads widened by five basis points to 695 over U.S. Treasuries, according to the EMBI-Plus. Brazil's portion of the index widened 20 basis points to 1139.

Wider spreads reflect the perception of increased risk as measured against safe-haven U.S. Treasury bonds. Yet Brazil remained much tighter, and much more popular with investors, than at the beginning of the year, when the country's spreads hovered in the range of 1450 basis points over Treasuries.

Despite the fact that Brazilian bonds have already rallied strongly this year and the risk that anticipated structural reforms may take a long time to implement, Latin America's biggest country remained a logical spot for new emerging market investors to put money, Ryan said.

"If you think Brazil's fundamentals are reasonably constructive, it has a good risk/reward so long as the government continues to say the right things," Ryan said.

In addition to pursuing long-elusive social security and tax reforms, Brazil's new government wooed Wall Street by increasing its primary surplus target to 4.25 percent of gross domestic product from the 3.75 percent set by the previous government.

While Brazilian total returns, which include price movements and accrued interest, have risen 3 percent so far this month, troubled Latin American countries like Ecuador and Venezuela have lagged.

In the wake of a national strike, organized by a coalition of opposition groups bent on forcing leftist President Hugo Chavez from office, Wall Street is worried about the governability of Venezuela.

And while investors like the policies articulated by Ecuador's new president, Lucio Gutierrez, implementation of those policies depends on the country's fractious Congress.

As investors search for higher-yielding bonds, such Latin American trouble spots tend to help make Brazil look good.

"If Brazil was at 800 (basis points) over, you could say the market is pricing in too many positive expectations," the trader said. "So if you are a portfolio manager with new money to invest, where are you going to put it? You are not going to put it in Venezuela or Ecuador."

Russia, which has seen its bonds clock total returns of more than 10.3 percent so far this year after a dramatic rally in 2002, "looks expensive," the trader added.

"Mexico is OK, but the upside in Mexico is not anywhere near what it is in Brazil. Plus Brazil has liquidity, so it's a logical candidate for money coming into the market," the trader said.