BRIDGE ANALYSIS: Emerging debt to stay on the sidelines By Felix Salmon, Bridge News New York--Mar 9--Dealers in emerging market bonds aren't as happy as they might be, given the recent run-up in bond prices. The problem is that volumes remain very low, and that the long-awaited crossover investors show no signs of returning to the market. As the US Federal Reserve continues to raise interest rates, some analysts are worried about how well-supported the Brady market really is. The Brady market has had 2 impressive upward spurts in recent months: first in November and December, as the market started discounting Y2K worries, and then again in February and this month, as Moody's first put Mexico on review for possible upgrade and then gave the country investment-grade status. Brady bonds have also proved impervious to the travails of the Dow. The Brady market tends to follow different things at different times: sometimes it's the oil price, often it's the Dow, but at the moment it's definitely the Nasdaq. "The forces of global recovery are winning out over the negatives associated with tighter US monetary policy," said Jorge Amato, emerging-market fixed-income analyst at IDEA. "There's an increase in risk appetite across all markets." But while volumes on the Nasdaq stock market have been rising to new highs during its recent rally, volumes in emerging bond markets are lackluster at best. The Emerging Market Traders Association (EMTA) has been conducting annual volume surveys since 1992, and quarterly surveys since 1997. The fourth quarter of 1999 saw the lowest quarterly volume EMTA ever measured, just $490 billion in face value compared with 7 consecutive figures over $1 trillion between 1997 and 1998. The year 1999 as a whole saw $2.18 trillion of volume, the lowest figure since 1993. It was a 48% decline from 1998 and represented just 37% of 1997's total. The drop in trading volumes was a function of the emerging markets crisis which started in Asia in late 1997 and reached its peak with the Russian defaults of 1998. Spreads ballooned out massively, many banks lost billions in Russia, and appetite for emerging-market risk dried up completely. Since then, bond prices have risen back towards their pre-crisis levels, while emerging stock markets are hitting new highs. But volumes are taking much longer to return. Many money-market banks merged with others or closed down their Brady desks completely; the rest sharply curtailed the amount of inventory traders could hold on the bank's books. Hedge funds, which had been some of the largest players in the market, exited en masse. For the past year or so, ever since the initial panic over Brazil's devaluation died down, analysts have been touting the imminent re-entry of what they call crossover investors--US names, usually, who mainly hold American corporate bonds, but who might also be interested in a bit of diversification. Now, however, the hopes for a wider investor base are dwindling. Yields on US high-yield bonds have been rising as default rates go up, even as yields on emerging-market bonds have been falling. The pick-up in yield that investors get by taking foreign risk has therefore diminished considerably. And then there's the Nasdaq. On the one hand, its seemingly unstoppable rise has helped keep emerging-market bonds afloat during the beginning of the Federal Reserve's tightening cycle. On the other hand, however, the returns seen in US technology stocks so far surpass anything in emerging markets that even Brady bond traders seem to be spending an inordinate amount of time trading Nasdaq stocks for their personal accounts. "It's a tough sell," admitted Pravin Banker, an emerging markets consultant and fund manager in New York. Banker said that much of the recent bull market in emerging-market debt was driven by local investors in Brazil, Argentina and Mexico, and added that there was a chance that if Asian markets stumbled, Latin America could easily fall in sympathy. With US investors sticking to what they know, many formerly common trades in the Brady market have become almost impossible to put on. A large part of volume once consisted of relative-value trades, where investors would buy Brazil and sell Argentina, say, or buy Mexican global bonds while selling Mexican Bradys. These trades not only had the potential of generating high re turns with low outlays, but also had the side effect of providing more liquidity to the market. Today's market, say traders, is so illiquid that such trades have become impossible. The market has been reduced to investors buying the credits they like, clipping the coupons when they come, and enjoying the gain in price. The fact that they have little reason to sell anything has contributed to the recent price action, say traders, where small buy orders can send prices sharply higher. The combination of high prices, low liquidity and a strong reliance on the continued health of the Nasdaq stock market is enough to keep most non-dedicated players out of emerging-market debt for the time being. The players in it aren't too worried: they're happy with their returns so far. The big losers in the game are mainly the emerging-market sovereigns themselves: they're having great difficulty tapping the dollar bond market, because there's simply so little demand for their paper. While they can make up for this to some degree by issuing in euros instead, the outlook for demand for emerging-market debt seems set to be bleak for the foreseeable future. End (Back) to felixsalmon.com