Emerging market debt tanks on Fed hike fears; off-the-run names, Colombia hit hardest

By Reshmi Basu and Paul A. Harris

New York, May 6 - It was a bloody day for emerging market debt as investors sold off risky assets on fears about when the Federal Reserve will raise interest rates.

No other catalysts appear to be driving the market as investors remain focused on the interest rate outlook.

"It's related to what's going on with Fed expectations again. And people are just dumping risk left and right," said a buy-side source.

"We had a little of a rally yesterday [Wednesday]. Supposedly the Street is very poorly positioned and it's killing our market."

The JP Morgan EMBI Index slid 1.95%. Its spread to Treasuries widened by 21 basis points.

"We had a tremendous back up and it's just brutal," said the buy-side source.

"But if you look where we were 18 months ago, we were at 1000 over on the EMBI.

"Today we're at 520. At the tight, we were about 400 or little less.

"We've had a decent back-up, this is normal," he said.

Brazil, Venezuela, and Russia were all down - way down. Their EMBI Index components saw spreads widen by double digits.

The Brazilian component was down 2.68 while its spread to Treasuries widened by 37 basis points.

While the market overall was down substantially, less liquid issues suffered most.

"It's the off-the-runs that are doing much worse," said the buy-side source.

"I don't know if that's catch-up or a function of liquidity - supposedly that's what the brokers have out on their books."

Those sentiments were echoed by a portfolio manager who had also heard that activity was "mostly fast money - with net buying in the most liquid bonds in Brazil, Venezuela and Russia."

Reflecting that trend, Brazil's bond due 2040 recovered from its early lows.

By mid-day, the buy-side source said he saw the 2040 bond doing better. He saw levels of 88½ bid, 89½ offered.

By the end of the day, it had recovered as far as 89.15 bid, 89.7 offered - but that was still down 2.90 points on the session.

The Brazilian benchmark C bond was down 1.56 to 90.125 bid, 90.250 offered.

And the massacre could spill into Friday if the U.S. employment figures beat forecasts.

Colombia feels pain

Among Thursday's worst performers was Colombia. Its component of the JP Morgan EMBI Index was down 3.17% on the day. Its spread to Treasuries widened by 35 basis points.

Portfolio adjustments, not political risk, are driving down the credit, as the political scenario has not altered in the last few weeks, said Alberto Bernal, Latin America economist for IDEAglobal.

As expected by Bernal, President Alvaro Uribe will prioritize his bill allowing him to run for a second term in 2006 over the pension bill or tax reform, a concept which investors have a hard time digesting, but should not find surprising.

"That should not be one of the reasons why the country is performing so bearish today [Thursday]," said Bernal.

"Most of the negative returns are a function of lag adjustments in terms of portfolio strategies from different investors around the world.

"Basically Brazil takes the lead. And everyone catches up."

"The credit can do little to stop the bleeding, only continue along the austere economic path."

"Eventually, whenever the market finds its new equilibrium, then we will start again from a more stable point," Bernal told Prospect News.

"But at times in which you have an adjustments on equilibrium, price levels and expectations regarding future world interest rates, a small credit like Colombia will suffer the lag adjustments."

In terms of market technicals, one piece of good news is that about 30% of all the external bonds are in the hand of locals.

"And locals tend to be more stable investors than foreigners, so the technical ownership of Colombian bonds is better than many of the countries in the region, like Ecuador or Peru," said Bernal.

For the most part, Argentina has been performing well because to an extent it is a story of restructuring, Bernal continued.

"And it's a story of expectations of the speed and capacity of the government and the bondholders to get to an agreement to bring the country out of default," said Bernal.

Interest rates do have an effect on the performance of Argentine bonds, but not in the same way as in Brazil, Colombia or Ecuador.

World interest rates will affect Argentina because when a restructuring agreement is reached, the market will look at world interest rates to generate an educated guess of what the discount rate for Argentina as a country should be.

"The state of world numbers will affect the exit yield," said Bernal.

"At this point in time, everyone understands that the end of the restructuring process is a long time away still.

"There's no reason for you to sell such paper, even if it is not paying you anything. It's like a hedging instrument at this point.

"People are not selling, that why Argentina is actually on a positive scenario this year, compared to everyone else."

Kaltim Prima attracts lookers

Indonesia's second-largest coal mining company's $375 million two-tranche offering is stirring up some interest.

"It's an interesting deal- very much like a Freeport in asset quality. We'll have to see how it goes given this environment," said the buy-side source.

Credit Suisse First Boston and JP Morgan are joint bookrunners on the Rule 144A/Regulation S deal.

The deal was originally scheduled to price Friday but in the current turmoil this is seen as unlikely to happen.

But despite unfriendly market conditions, Slovakia may be able to price its planned offering of €1 billion 10-year notes, via ABN Amro, Dresdner Kleinwort Wasserstein, and Morgan Stanley.

Slovakia finished investor meetings on Thursday and is expected to price on Friday.

Given that the issue is investment-grade, it attracts a different universe of buyers, said the buy-side source.

Meanwhile the Kingdom of Thailand priced $1 billion of three-year floating-rate notes at 99.94 to yield 6-month Libor plus 13.5 basis points.

The deal priced on the cheaper end of talk which was for six-month Libor plus 12.5 to 13.5 basis points.

A market source said the "books were fully subscribed."

Barclays Capital was bookrunner for the Regulation S deal.

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