Emerging-market dollar bond spreads narrowest since 2007, investors turn defensive

As the global credit selloff deepens, emerging-market investors are cutting positions in the riskiest bonds. From Aegon USA Investment Management to JPMorgan Asset Management, money managers worry that surging global interest rates could end emerging-market debts strong performance. Even after a recent bout of turbulence that drove Treasury yields to near 20-year highs, emerging-market dollar bonds have still returned 1.4% over the past year. Yet credit spreads have narrowed to the tightest since 2007, even with oil above $100 a barrel and investors bracing for higher for longer global rates. Thats making fund managers uneasy, who see the bonds as primed for a selloff. When government rates rise, I get a little bit concerned about what that means for spread levels, said Jeff Grills, head of emerging-market debt at Aegon. When I look for big opportunities, its hard to find them. He recently trimmed exposure to Colombia while adding to debt from higher-rated borrowers such as Indonesia, Saudi Arabia and the Philippines. He isnt alone. Neuberger Bermans Gorky Urquieta has reduced positions in high-yielding debt from Ecuador, the Dominican Republic and Zambia, and is struggling to find ways to add risk to his portfolio. Weve been in a bit of a shrink mode, Urquieta said. The pullback comes after emerging markets weathered a sharp global interest-rate repricing and conflict in the Middle East. Sticky inflation and a resilient US economy have driven Treasury yields higher as traders bet on a more aggressive Federal Reserve tightening path. But emerging-market dollar bonds have so far held onto their gains. The spread on developing-nation dollar debt over Treasuries is just 170 basis points, the narrowest since 2007, according to JPMorgan data. That relative strength is one reason investors are uneasy. Valuations remain elevated, and the sharp rise in Treasury yields means emerging-market credit has less room to absorb another global rate shock without a significant widening in spreads. Industry research sees Fed policy as the main risk for hard-currency emerging-market debt in the fourth quarter, and says spreads near a 19-year low could amplify shocks to individual country bonds. Caution is also starting to show up in fund flows. The largest ETF tracking emerging-market hard-currency bonds last week saw one of its biggest single-day outflows since March. Some investors are opting to raise credit quality rather than abandon emerging-market debt altogether. PPM Americas Matt Graves is adding duration through higher-rated borrowers such as Morocco while cutting riskier positions that performed strongly earlier this year, such as Angola. Others see opportunities in beaten-down investment-grade bonds amid the Treasury selloff. Fernando Grisales, a senior portfolio manager at Schroders in New York, added to Saudi Aramco and Mexican dollar bonds. Value is emerging in the long end of the investment-grade credit curve, and those credits are very solid, he said. JPMorgan Asset Management is taking a different route. Pierre-Yves Bareau, its head of emerging-market debt, is reducing his portfolios sensitivity to a credit selloff and shifting some risk into local-currency bonds, including Mexico, because he believes the swaps market is pricing in too many rate hikes. Local-currency debt is still up an average of 0.9% this year, while a gauge of developing-nation equities has risen more than 23%, beating developed-market stocks. Higher local rates and elevated commodity prices are also making markets such as Brazil and Colombia attractive to investors. We are taking slightly less risk, Bareau said. Were playing the other side more through local markets rather than credit.