Emerging Markets: Yields and Spreads

Alphaville's Gwen Robinson has gotten her hands on some research from CLSA's Christopher Wood, who foresees emerging-market debt yields even lower than the yields on US Treasury bonds. I haven't seen the research myself, but I hope it isn't as confused about the difference between yields and spreads as Robinson seems to be.

Robinson notes that Japanese bond yields fell below US bond yields in the 1970s, and then adds:

This historic episode raises the issue today of the potential for emerging market debt yields to trade eventually through US Treasury bond yields, says Wood.
The possibility of such an outcome can no longer be dismissed out of hand, he adds, “given the ability of emerging market debt spreads to continue to decouple from rising credit spreads in the US”.

She does the spreads-to-yields switcheroo a second time, too:

His guess is that emerging market debt spreads “will suffer a bit of a wobble if commodities are hit, most particularly the oil price”. But if commodities remain strong, “the surprise will be that debt spreads in the emerging area will keep declining whatever happens to CDOs, CLOs and the like”.
Indeed, if structured finance “completely blows up”, Wood says, “this could even lead to increasing demand for emerging debt given the shrinking supply of such paper”. That is how emerging debt yields could eventually trade through US Treasuries, in Wood’s view.

The elephant in the room that Robinson is so carefully dancing around, here, is the whole question of currencies. In order to compare yields in yen to yields in dollars, you first need to do a currency swap. And if you do that, you'll find that Japanese yields are, in fact, higher than US yields, just like they always have been.

On a like-for-like comparison, nothing trades through US Treasuries, which remain the gold standard, the risk-free benchmark. The only way that EM yields will ever trade "through US Treasuries" is if you ignore the currency component: that is, if you compare yields in Czech koruna, say, to yields in US dollars. Which is no consolation at all to someone who goes short koruna and long dollars in a carry trade, only to see the Czech currency soar against the dollar.

On a nominal basis, it's relatively easy for interest rates in an emerging-market country to fall below interest rates in the US. All you need is for that country's central bank to set its own overnight rate at a level lower than the Fed funds rate, and presto – at the short end of the curve, at least, that country is "trading through Treasuries". Big deal.

But there is an important point here: emerging-market sovereign debt, which has been trading through US high-yield debt for some time, now, could soon start trading through US high-grade debt as well. That's because the big borrowers of old, like Argentina and Mexico, no longer issue dollar-denominated debt in any significant quantity, so demand vastly exceeds supply.

Sovereign countries haven't stopped defaulting, of course – just look at the shenanigans in Ecuador. But most commodity-rich emerging-market countries now lend much more to the US than they borrow from it. In that context, it's hardly surprising that their debt will remain attractive. But EM spreads over Treasuries, if you look at dollar-denominated debt, will never turn negative.