Emerging market debt recovers from London bomb attacks; funds see inflows of $297 million

By Reshmi Basu and Paul A. Harris

New York, July 7 - Emerging market debt recovered Thursday after a sharp decline earlier in the session following deadly bombings in London.

During London's rush hour, there were reports of four explosions on the city's transport system, which left at least 37 people dead and 700 injured.

"When London opened, everything fell, said a sellside source.

"But then New York came. First there was panic. Then Treasuries started to lose ground a little bit," said the source, which caused a fall in emerging market debt.

But the market regained composure as U.S. Treasury prices rose on a flight to quality.

A second sellside source noted that the JP Morgan EMBI+ Index was six basis points wider at mid-morning, adding that many of the on-the-run high-grade names were wider by four basis points. By the end of the session, the index was up 0.13% while its spread to Treasuries tightened by two basis points to 302 basis points.

"I would say that the [EM] market is pretty resilient, everything considered," said the second sellside source at mid-morning.

The Brazil bond due 2040 was basically flat by mid-day, after having been down as much as 50 to 75 cents earlier in the session, according to the second sellside source.

"Of course you've had a fairly large rally in Treasuries at the same time," noted the source.

"Now the 30-year Treasury is flat. So the flight to quality is focused on the short end to the middle of the curve."

The yield on the 10-year note fell as low as 3.937% in reaction to the bombings, but closed the session at 4.04%, still improved from Wednesday's 4.07%. Friday's release of non-farm payroll numbers in the United States put a lid on gains, said sources.

"Brazil has somewhat tightened between five to 15 basis points," said the first sellside source.

"Colombia is neutral. Mexico is mixed.

"But in general, all markets have held their ground," he said, adding that prices have risen because Treasuries are tighter from Wednesday's close.

"Much lower treasury yields and parallel spread development buffered most of the London impact on EM debt," said an investor in Asia.

By the end of the session, the Brazil C bond was up 0.374 to 102.187 bid while the bond due 2040 gained 0.35 to 118.55 bid. The Russia bond due 2030 gained 1/8 of a point to 111 1/8 bid. The Philippine bond due 2025 was down two points to 108 bid.

The second sellside spotted the Philippine bond due 2030 at 98 bid, 98¾ offered in early trading, saying it was certainly down more than the overall market

"Some of this is the Arroyo stuff, but it's partly the market. Overall I think the Philippines has held up pretty well," added the source.

"I think that the price action has been pretty tempered. But I think investors are going to want to have a little time now," remarked the source.

Inside the initial reaction to London bombings

Liquidity was low in London, according to a market source, who added that only benchmark issues for Russia, Turkey and Brazil traded at narrow spreads.

Meanwhile, Asian credits opened weaker in New York on the news. According to the source, there were no trades at the wider levels while both high grade and high yield saw firmer spreads after the initial reaction.

Overall, Turkish bonds had little reaction, said the market source, adding that bonds strengthened in the afternoon. Turkish local bond yields widened by only 10 basis points.

The London news had little to no impact on Russia's local bond market, said the market source. But the local equity market dipped, reflecting lower global equity prices.

EM funds inflows at $297 million

Mutual funds saw healthy inflows this week. Emerging market bonds had inflows of $297 million during the week ending July 6, according to EmergingPortfolio.com Fund Research.

These funds now have had $3.767 billion of inflows year-to-date.

EmergingPortfolio also reported positive flows into high-yield, reversing a four week slide.

U.S. Treasuries backdrop unsupportive, says investor

Yields on U.S. Treasuries dipped below the psychological 4% barrier earlier in the session Thursday. Nonetheless, Treasuries form an unsupportive backdrop to emerging markets, according to Steve M. Hope, managing partner of Outrider Management.

"I think the market has underestimated the Fed in terms of their willingness to keep on raising rates, their willingness to have an inverted yield curve," he said, as well as "their willingness to tolerate economic weakness to prick the housing bubble."

Nonetheless, Hope predicted a quiet summer for the asset class.

"There's some political rumblings but most of those are probably buying opportunities."

"And three months from now, prices will probably be about where they are."

"Until the U.S. Treasury market falls out of bed, the emerging market bond market should do reasonably well," he said.

He added that it yet to be seen whether the potential drivers that could trigger a sell-off in Treasuries are positively or negatively correlated with emerging markets.

"I just think that the 10-year doesn't care what the funds rate is, so in that context it's hard to know what the bond market will do," he said.

He added that he, like many, is unclear as to what the supply and demand factors are that are driving long-term bond prices.

"The short-term rates aren't necessarily a very good indicator with what will happen in the long-term."

In terms of buying opportunities, Hope is looking at short-term durations, given that he foresees the market coming down.

Brazil versus Philippines

Both governments in Brazil and the Philippines have been battling allegations of political corruption, which has weighed down on their sovereign bonds.

In Brazil, president Luiz Inácio Lula da Silva and his Workers' Party are fighting charges of paying off members of congress for support of government-backed legislation.

In the Philippines, president Gloria Arroyo has been dogged by allegations that she fixed last year's close presidential election.

For Hope, the scandal in the Philippines has yet to produce a buying opportunity.

"Within the next five years, we will probably see Philippine bonds trading 60 to 80 cents, but having said that, I wouldn't be at all surprised if say, the Phili '30s traded above par in the next few weeks," he noted.

"If you believe in the Philippines for the longer term and think they are a recovering story, it's a buying opportunity."

Hope, however, is not a believer in the story nor does that he believe that the Philippines is a longer term high-grade credit story.

"So I don't want to lend money to them at 9%."

Brazil, on the other hand, is a better story, noted Hope, adding that the country has a better chance of breaking through to become an investment-grade credit.

"There too, the odds are stacked against them and the political noise is potentially debilitating," he remarked.

Although he added that the scandal has resulted in more worry than devastating effects.

But from a fiscal standpoint, the Philippines has an orthodox government that is in political trouble, noted Hope.

"In the Brazilian case, you have nominally at least, the leftist party that's got a political crisis. Who replaces Lula? Who replaces the PT if they lose in the next election?

"And the answer is: somebody who generally by and large, the market liked better in 2002," said Hope.

Moreover, both political stories are different, he remarked.

"The big risk from a political standpoint in Brazil is that the PT is so worried about its standing in the next upcoming election that they start loosening fiscal targets or they launch pork barrel projects.

"But Lula seems like he is determined to govern properly," noted Hope.

Whether or not Brazil's congress is accommodating is another issue and whether the Workers' Party will stand by Lula if his popularity falters is yet to be seen, added Hope.

"But I really think that the risk is much greater in the Philippines than Brazil."

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