Emerging markets gain further as credit fears ease; Brazil presses higher; funds lose $832 million

By Paul Deckelman and Aaron Hochman-Zimmerman

New York, Aug. 24 - Emerging market bonds continued to move up Friday, with investors becoming more confident that the recent credit crunch sparked by the problems of the U.S. subprime lending sector won't have too much impact. And for a second straight session, they took heart from Moody's Investors Service's upgrade of major EM issuer Brazil's debt ratings to just one small step away from investment grade.

Bonds of Brazil and Argentina were seen on the upside in late trading. Outside of Latin America, Philippines debt steadied in earlier trading in the Far East, while the price of credit default swaps contracts linked to Bank of China debt gyrated after that institution and two other big Asian banks reported they have sizable exposure to the subprime sector - but eventually fell as investor concern subsided.

Emerging markets bond funds, meanwhile, had their second worst week of the year, losing $832 million, according to EPFR Global.

U.S. Treasury issues were mostly continuing to fall as the flight to safety by investors seen earlier in the week tapered off and in response to signs of strength in the U.S. economy - new government data showed that both home sales and orders for durable goods beat analysts' expectations in July. That in turn was a factor as spreads between emerging bond yields and Treasury yields - considered the key measure of investor aversion to risk, or tolerance of it - continued to tighten.

Yields of shorter-maturity Treasury paper, the safe haven of choice recently for emerging debt holders and other investors looking to cut down on their risk assumption, were seen rising on Friday, as the flight to safety phenomenon abated. Yields of three-month T-bills, which had reached two-year lows at 2.505% as the week began, moved upward over the next four sessions, finishing Friday up 31 basis points at 4.22%. Two-year federal paper yields rose 2 bps to 4.29%, although the benchmark 10-year notes were higher and their yields fell 3 bps to 4.62%.

Against that backdrop, average EM spreads, as measured by the widely followed EMBI+ index compiled by JP Morgan & Co., narrowed by 4 bps to 228 bps.

Brazil rate boost continues impact

Latin American debt was seen mostly higher, helped by the signs of economic renewal in its big neighbor to the north - the main trading partner and export market for many countries in the region - as well as the continued afterglow from Thursday's rate boost by Moody's, which brought the rates for the senior debt of Latin America's biggest economy, Brazil, to Ba1, just a step away from investment-grade status, in line with ratings assigned by other agencies.

That helped to push the cost of CDS contracts on Brazilian government paper down by 9 bps on the day to around 100 bps, its lowest level in several weeks.

In cash bond trade, Brazil's dollar-denominated 7 7/8% global bonds due 2015 were quoted having risen to 111.07, up nearly ½ point from Thursday's level, and up more than a full point from where they had been on Tuesday. The bonds' yield fell 7 bps to 5.94%.

Brazil's local-currency bonds also did better, helped by solid gains posted by its currency unit, the real, in foreign-exchange trading. The yield on those benchmark zero-coupon bonds due 2008 declined by 6 bps to 11.28%.

Argentina, Mexico gain

Elsewhere, Argentina's 8.28% dollar-denominated bonds due 2033 rose 2 points on the day to 83.5. The risky bonds of Argentina and fellow high-beta credits Ecuador and Venezuela are generally among the largest gainers when the market is moving up - and the biggest losers when it's going the other way.

Mexico's 6 5/8% globals due 2015 moved up slightly, quoted at 105.66, as investors mulled over that country's central bank's not-unexpected decision to leave its key overnight lending rate unchanged at 7.25%, rather than raising it, as inflation showed signs of remaining in check, and as officials worried about the possibility of a global economic slowdown.

Philippines steady; bank's CDS recovers

In Asian trading earlier in the session, the Philippines' benchmark 2031 bonds were seen pretty much holding steady at 105.375 bid, 105.5 offered, while its 2032 bonds hung in at 95 bid, 95.625 offered. Meantime, the cost of a five-year CDS contract on those bonds - which on Thursday had fallen by some 16 bps - was little changed, quoted at around the 178 bps level.

Meanwhile, the normally little-traded CDS contracts linked to Bank of China's paper were seen having dropped in price into the lower 50 bps area, after having shot up about 15 bps in Thursday's dealings to around the 70 bps level after the state-operated bank said it had some $9.8 billion of securities backed by U.S. subprime loans. It was one of three large banks - the others were the bank's BOC Hong Kong subsidiary, which acts separately from its corporate parent on most matters - and Singapore-based DBS Bank - which reported collective holdings of some $13 billion of subprime-linked asset-backed securities.

While the debt markets, after the initial upward flurry in CDS prices, seemed to be not too concerned about BOC's exposure, if the fall in the CDS prices are any indicator, equity investors were not as forgiving, as the company's shares plunged more than 5% in Friday's Hong Kong trading.

Bad week for EM bond funds

Emerging markets bond funds, meanwhile, "had their second worst week of the year," declared Brad Durham, managing director of EPFR Global in Cambridge, Mass., which tracks daily and weekly money flows into and out of several thousand equity and bond funds worldwide, including over 400 funds which specialize in emerging markets debt.

Redemptions were $832 million in the week ended Wednesday.

And while the third week in April had actually seen more money having hemorrhaged from the emerging bond funds than was withdrawn in this past week, Durham noted that redemptions were broadly spread across more funds this time around.

EPFR Global noted that the latest outflows were mirrored by another week of poor fund performance by the emerging bond funds and bond funds in the non-emerging global category, with those tracked by the company posting a collective loss of 0.78%, a week after they had slid 1.38%.

But the picture was not all gloom and doom.

Durham said that over the last several days, according to EPFR Global's recently launched daily fund flow tracking program, the intensity of the outflows from emerging bond funds seemed to ebb. While the strongest outflows were seen over the period from Aug. 15 through Aug. 17, representing the time when the emerging debt market, along with other global and domestic financial markets were in the most credit crunch-related chaos, prompting last Friday's surprise move rate-cutting move by the Federal Reserve. After that, the flow of money out of the bond funds seemed to moderate substantially.

He said that the outflows "tapered off" from $182.1 million this past Monday, which he characterized as still "strong" outflows, to $36.5 million on Tuesday and $68 million on Wednesday. That seemed to roughly coincide with the improved performance in the EM bond sector in the wake of the Fed rate cut and the climate of hope it encouraged; while bonds were gyrating around last Monday, only to give up early gains and end mixed to lower, a decidedly better tone was seen after that.

While there's an approximate parallel there, the EM funds were still bleeding money even as the market itself was going up - but Durham explained that such a divergence between what the market is doing and what fund flows are doing is actually "fairly typical. You don't see the sudden shift, especially in fund flows, where there is a sort of residual effect - it takes a couple of days, in some cases for a transaction to take place, for an investor, especially if it's an institution, to redeem assets from a fund...it's not an instantaneous reaction [that shows up in] the fund flow data." Even so, he pointed out, "the less intense outflows are a sort of bullish indicator."

He said that the proprietary trading desks and the hedge funds, which he characterized as "the more nimble actors within emerging markets fixed income - are probably the first movers." Also, he mentioned, "the funds themselves may very well be buying from their cash positions - so the fund managers themselves may have turned bullish, but the underlying investors who are putting money into the funds or taking money out, are not acting quite as rapidly as the fund managers are.

"When flows are really strong out of a fund, you can be pretty certain that the fund manager is feeling some pressure to sell, just to meet redemptions. When the redemptions are not that strong out of a fund, the fund manager can move into the buying mode."

The fact that there were outflows on the days that the market seemed finally to have turned higher "doesn't mean that the funds weren't buying emerging market bonds on Tuesday and Wednesday," Durham concluded, "it just means that the pressure on a fund manager to sell was not as strong as it was earlier in the week."

Hope grows in primary

In the primary market the sun continued to burn off some of the clouds hanging over emerging markets, although there was still no news on international deals.

Demand for new issues exists, but it needs to find the right conditions, a market source said.

Conditions are not perfect, but during this week they have shown consistent improvement.

As the day was winding down, markets were looking better, said a buyside source.

"Sovereigns are trading quite strongly," the source said, adding: "There is more appetite for risk."

Even in local markets conditions improved.

"Local markets like Brazil got some tailwind," the buyside source said.

"All local currencies are better ... everything is strong, Brazil's, Mexico's, Colombia's currencies" are all stronger, the buysider said.

Labor Day in the United States is the unofficial end to the summer vacation season, but that does not necessarily mean the end of the troubles weighing on emerging markets.

"I think the market wants a significant rally in EM corps but every uptick is met by more supply," said an emerging markets analyst who specializes in Latin America.

The outflow totals for the week mean that there is leaving plenty of supply around the market.

"Brazil corps for the most part are on decent footing now, though the beef sector - Friboi, Bertin, Marfrig, Independencia and Minerva - are clearly better offered," the analyst said.

Further, all high yield [Argentina's corporates] are better offered no matter which way the market turns and sketchy Mexican credits like Unidas are under supply-induced pressures as well," the analyst said.

"I don't believe we've seen the end of this by any stretch of the imagination," the analyst said about a possible turnaround after Labor Day.

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