Brazil leads emerging market debt rally

www.upi.com By Bradley Brooks UPI Business Correspondent From the Business & Economics Desk Published 3/10/2003 7:05 PM

RIO DE JANEIRO, Brazil, March 10 (UPI) -- Brazil is leading the Latin American bond market to its biggest rally in more than four years, largely because of a socialist president's surprisingly austere financial moves.

While analysts are concerned a war in Iraq will damage emerging economies in numerous ways -- high oil prices spiking inflation, stock markets bottoming further -- those who follow bond markets say military action might actually aid the bond sector, as investors abandon equities for government debt.

"Clearly, the higher aversion to risk from the Iraqi war uncertainty is combining with a realization of the remarkable returns emerging market bonds have given in the last three to five years," said Brad Durham, director of fund research at the Boston-based EmergingPortfolio.com.

"It's really exceeded about all other asset classes out there."

Developing countries such as Russia, Brazil and Mexico -- the top three emerging-market bond issuers, according to Durham -- have seen their debt become attractive in the last six months as investors leaving turbulent equities are lured by the high returns on bonds.

Since October, J.P. Morgan Chase & Co.'s EMBI Global bond index has shot up 19 percent, with many nations gaining each month since that time. Not since 1998, just before Russia's default, have emerging bond markets seen such sustained success.

"I really think risk aversion plays into the hands of the emerging bond markets," Durham said. "It hurts equities, but it plays toward fixed income, just as being a safer investment, a safer asset class."

According to Durham's research, emerging-market bonds brought in $380 million net in the first seven weeks of this year -- about triple the year-earlier period.

Driving investors to emerging bond markets as well are the slim returns on U.S. Treasurys. Emerging market debt such as Brazil's benchmark 8 percent bond due 2014 yields 14 percent, or about three times as much U.S. bonds, too good an option for investors to pass up with anemic equities worldwide.

These returns are finally being noticed, analysts say.

"Emerging market bond funds have had a remarkable performance in the last five years, yet in every year up until 2002, investors were pulling money out," Durham said.

"At some point in 2002 there was a sentiment shift, a realization that this asset class has provided phenomenal returns -- something like 17 percent annual returns in the last five years."

For Brazil in particular, the shift was dramatic.

The country's bond lost one-third of its value in the first nine months of 2002, as investors fretted over the campaign and then election of President Luiz Inacio Lula da Silva, a leftist many feared would drive the country to default on its $240 billion debt.

Before the election, Brazil's bond sunk to 44 cents on the dollar, yielding 28 percent.

Since that time, it has risen to 75.88 cents, yielding 14.55 percent. Fitch Ratings on Monday raised its outlook on Brazilian debt to stable from negative.

One New York fixed-income strategist said that Brazil's rise is attributable to the surprising continuity in government policies Lula's first months have offered, and the notion that bluer skies are ahead for emerging debt.

"The assumption here is that once the war is over the market will do well, so we're seeing anticipation of that in Brazil," the strategist said.

"A lot of people are saying maybe Brazil has gone as far as it can go, but some people are obviously betting the opposite, as the run there has shown."

Not all emerging market bonds are faring so well, which analysts say is consistent with growing sophistication on the part of investors in terms of recognizing individual country risk.

The most striking example is that of Brazil and its neighbor Argentina, which defaulted in December 2001.

But there is also the case of Venezuela, where the struggle between President Hugo Chavez and his detractors has sent foreign capital fleeing.

Also, Uruguay's bond markets aren't exactly bouncing, as investors see that the country felt the brunt of Argentina's meltdown.

"Latin external credit markets have decoupled decisively of late from Latin local markets," a Morgan Stanley report this week indicated, highlighting the difference between Brazilian bonds and equities.

"Inflows into external debt funds continue and their deployment contributes to the sustenance of the credit rally."

Morgan Stanley did indicate it sees some sort of corrections as probable, either in a credit sell-off or cash being directed towards equity markets if and when they improve.

Durham said as well that despite a war with Iraq being priced into markets and actually spurring investors into bonds, a more protracted conflict could eventually hurt emerging market debt.

"Emerging markets, just because of the reputation they have for volatility, could see a flipside there," he said.

"But I don't really see much of a plummet, even in equities, after a war begins. I wouldn't be surprised if there was something of a rally."