Outlook 2013: EM returns will be solid but not as great as 2012; spreads too narrow to compress

By Christine Van Dusen

Atlanta, Dec. 31 - It is going to be another good year, but not that good - that's the prevailing prediction for emerging markets debt in 2013.

"Most market participants are expecting another solid year next year but without the major gains of this year," a London-based trader said.

While 2012 had a rocky start - with slower economic growth in emerging markets and continued anxiety about the global financial picture - spreads later narrowed and a better picture emerged as a result of central bank moves.

"The aggressive policy maneuvers have disrupted, if not ended, the cycle of crisis and intervention that had dominated markets through the sovereign crisis," said Jeff Meli, head of credit research for Barclays.

So the year ended on a fairly high note that is expected to carry on into 2013, though returns are expected to be slightly lower.

According to the JPMorgan Emerging Markets Bond Index Plus, emerging markets debt saw returns of as high as 20% in 2012 - a figure that's unlikely to be repeated or exceeded.

"Spreads have compressed quite dramatically over the last year to two years, and it seems unlikely to me that we're going to be able to generate the same kind of spread compression," said Nick Chamie, head of emerging markets research for RBC Capital Markets.

Treasury yields are forecast to rise about 40 basis points in 2013 while spreads are expected to compress between 50 bps and 85 bps, according to JPMorgan research. In 2012, spreads tightened as much as 124 bps.

"Valuations have reached the point where they're becoming a partial binding constraint," Chamie said. "The underlying Treasury yields have compressed to a level that can't see significant declines from here."

Barring any sudden spike in inflation or a surprise related to the United States' fiscal-cliff talks, the new year still should see continued strong demand and tight spreads.

"Overall this asset class continues to grow, develop and become an integral part of any investment strategy," the London-based trader said.

Said a Connecticut-based trader, "Investors will be looking for high-yielding assets where they can find them."

And they'll look for them in lagging areas of the market, including BBB-rated bonds, Meli said.

"The need to move further out the risk curve to seek outperformance, combined with a potential rise in idiosyncratic single-name volatility, will translate into an environment in which a good bond is hard to find," he said.

Investors will move to Asia

Investors are expected to shift into bonds from Asian sovereigns but would benefit from reassessing their exposure to some names, including Indonesia, which could face some political turmoil as a result of the 2014 elections.

Barclays recommends that investors increase their exposure to Chinese property companies.

And most market sources aren't huge fans of local-currency deals at the moment.

"Going forward, local currency bonds will likely perform more in line with local growth and inflation dynamics," according to a report from Commerzbank.

Said Chamie, "We expect more balance between hard currency and local currency this year."

LatAm in focus

Corporate issues from Latin America, emerging Europe and the Middle East should perform in line with their developed-market counterparts in 2013 while outperforming EM sovereigns, Barclays said.

"Like other credit asset classes around the world, Latin America and EEMEA corporate bonds will in 2013 be caught between enormously supportive monetary policy and somewhat weaker fundamentals," the report said.

Among the bonds favored for 2013 from Latin America are Brazil-based Banco Bradesco SA's 2021s and Itau Unibanco Holding SA's 2022s.

"We expect overall performance to decline from very strong 2012 levels, but to remain positive in 2013," Bank of America Merrill Lynch said. "We forecast LatAm corporates to return 4.2% in 2013."

And bonds from Venezuela are expected to remain attractive in 2013, as are those from Brazil, Colombia and Latin America's consumer and construction sectors.

Argentina's economy will remain volatile, which could lead to some corporate defaults, a market source said.

Vimpelcom gets thumbs up

From Russia, Vimpelcom's 2017 bonds are expected to be solid performers in 2013.

And underweight positions are recommended for Ukraine, Romania and Lithuania.

Some market sources are recommending Russia over Mexico's single-B bonds.

From Abu Dhabi, Dolphin Energy is attractive, given its strong fundamental profile and project finance structure, Barclays said.

Long-dated bonds popular

Long-dated bonds from various issuers are expected to remain in favor in 2013, the London-based trader said.

"The theme of duration was impressive," he said. "Long-dated bonds in the majority of regions performed exceptionally well."

Abu Dhabi-based International Petroleum Investment Co., for one, saw its 2041s go to 142 bid in December 2012 from 101 in December of 2011, he said.

Demand expected for Africa

African sovereigns and corporates should see strong demand in 2013, the Connecticut trader said.

"More corporate issuance out of Africa will be well received, given that there's a decent amount of money earmarked for African issues," he said.

One trader plans to keep an eye on South Africa-based Investec Ltd., which finished 2012 on very solid footing and with two-way activity on its 2017 notes.

"Many are predicting this bond could be a nice little performer in the first quarter next year," he said.

Risks remain

To be sure, the market could hit some headwinds; developing countries are particularly susceptible to undulations in the global economy, and EM debt stands to suffer when risk appetite declines.

EM bonds are "subject to increased interest rate sensitivity, a risk that is untested in the current environment and underappreciated by many investors," according to a report from Bank of America Merrill Lynch.

So market sources are keeping an eye on the economic picture in China and the United States, as well as any turmoil in the Middle East.

There's also a risk that investors could rotate out of bonds into equities, the London trader said.

"That could develop into a real theme during the first quarter or half of next year," he said. "Technicals should remain fairly strong as more new players enter the market - crossovers, pension funds, etc."

Inflows expected to decline

In terms of inflows, emerging markets bond funds are expected to see a minimum of $70 billion in 2013, down from the 2012 year-to-date total of $85 billion, JPMorgan said.

"Inflows into EM debt are becoming counter-cyclical as EM countries continue to benefit from ratings upgrades, and the proportion of higher-rated issuance has increased," the bank said.

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