Market Extra: The dollar rally is punishing emerging-market bonds, after year of record issuance

Emerging-market bonds are reeling as a result of the dollar’s rebound, which is putting a strain on countries and corporations that found it difficult to resist issuing debt in the U.S. currency.

“The dollar remains the single most important consideration for EM finances,” said James McCormack, global head of sovereigns for Fitch Ratings. “A stronger dollar will be associated with a weakening of EM economies’ external balance sheets.”

Borrowers weren’t ignorant of the risks but, for some, the allure of selling debt in dollars was too attractive to dismiss. Issuing dollar-denominated debt instead of government paper in local currencies can often result in cheaper borrowing, as risk-averse investors paid a premium for receiving interest payments in the more stable greenback. That’s because volatility in emerging-market currencies can wipe out the gains accrued from the high yielding, emerging-market bonds.

The dollar, which has been on a largely uninterrupted rise since mid-April, notched a 2018 high on Wednesday, while Treasury yields continue to climb, with the rate on the benchmark 10-year note TMUBMUSD10Y, +0.24%  topping 3.10% on Wednesday for the first time since July 2011.

The ICE Dollar Index DXY, +0.17% which measures the dollar against a basket of six major rivals, is up 4.8% over the last three months to 93.393.

Exchange-traded funds linked to benchmark emerging-market bond indexes have seen negative returns, most prominently in the dollar-denominated iShares J.P. Morgan USD Emerging Markets Bond ETF EMB, -0.40% which was down 4.9% year-to-date.

McCormack said emerging-market bonds were particularly sensitive to a strengthening dollar as it forced their central banks in those countries to drain foreign-exchange reserves to halt local currencies from sliding against the buck. However, depleting those accounts means fewer dollars available for interest payments, pushing investors to demand richer yields as compensation for holding riskier debt.

The New York Federal Reserve’s custody holdings of Treasurys, which often reflects foreign-exchange reserves held on behalf of non-U.S. central banks, has dropped more than $60 billion to $3.04 trillion as of May 9, from a peak of $3.11 trillion in March. That suggests that foreign central banks, indeed, are using dollars to buy up local currencies, lifting their values.

In the attached chart from Fitch Ratings, credit ratings for emerging-market, government bonds move in tandem with the dollar’s movements. That reflects the amount of borrowing done in a foreign currency by emerging-market entities. Total issuance of U.S. dollar-denominated bonds by emerging countries doubled to more than $11 trillion between the end of 2007 and September 2017, according to the Bank for International Settlements.

Emerging market credit ratings has largely followed the dollar’s moves

It isn’t just government bonds issued by emerging-market governments that have come under pressure.

“Given the propensity of emerging market [corporations] to also fund themselves in the U.S. dollar,” corporate debt has also faltered as dollar-inflated borrowing costs eat into profit margins, said Solomon Tadesse, cross-asset strategist at Société Générale.

That’s particularly true for Turkey, which has borne the brunt of the punishment in the emerging-market selloff after the Turkish lira USDTRY, +1.0625%  fell more than 17% against the buck. Its private sector debt now stands at around 70% of gross domestic product more than half of which has been issued in foreign currencies, according to the International Institute of Finance.

Cash-rich corporations will sometimes issue debt in the greenback to reap the difference from borrowing in low U.S. interest rates and lending in higher local rates through domestic bank deposits or money market instruments.

Before April, investors were rosy on the outlook for emerging-market debt even after a break-out in Treasury yields at the beginning of the year that could have cut into appetite for such bonds.

Strong global growth had kept a steady inflow of money moving into emerging-market assets as investors turned away from U.S. valuations considered elevated. Issuers, in turn, took advantage of the pickup in demand, issuing more than $450 billion of bonds in 2017, an all-time annual record, according to CreditSights.

Holger Mertens, global credit fund manager for Nikko Asset Management, blamed part of the selloff in emerging markets on “overpositioning” as investors had become too bullish on the sector.

But emerging markets were supposed to be insulated from a stronger dollar this time around.

Governments and central banks from countries like Argentina worked hard to narrow their current-account deficits, which roughly matches the size of the trade deficit, and steadily accumulated foreign currency reserves. The current-account deficit for emerging market economies has narrowed to $26 billion in 2017 from $91 billion in 2016, according to International Monetary Fund data.

Moreover, many emerging-market issuers have sold debt in local currencies rather than dollars. Buyers of local-currency bonds should in theory have shrugged off the ups and downs of the greenback.

That hasn’t prevented the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF EMLC, -1.00% from losing a modest 2.5% year-to-date.

“Investors, facing the prospect of being repaid in cheaper currency, are likely to demand higher yields, generally sending bond prices lower,” said Kathy Jones, chief fixed-income strategist for Schwab Center for Financial Research.

Yet some expect the dollar’s rally to be short-lived. A combination of the U.S.’s yawning trade deficit and a widening budget deficit is likely to cap the dollar’s rebound this time around, said Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley Wealth Management.

But if the dollar continues to rally, “faith in better EM macroeconomic and credit fundamentals in support of a view that ‘this time is different’ is equally misplaced,” said McCormack.

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