Investors Are Dumping Emerging Market Debt At A Record Pace

Having warned that Emerging Market debt risks had hit 10-year lows (despite soaring uncertainty) and EM equity risk had hit record lows (amid record inflows), it seems the lagged impact of the collapse in the China credit impulse is finally being recognized as the largest EM Debt ETF (from JPMorgan) just suffered its largest outflows in history...

As a reminder, in the run-up to this dumping of EM assets, expected uncertainty in Emerging Market Equities has never been lower... (in fact EEM implied vol is now less than half its lifetime average of 29.7%)

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What was even more stunning than investors' tolerance for these risky issuers is how little compensation they’re demanding in return.  Emerging Market bonds were pricing in the least 'risk' since Dec 2007...

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The disconnect is a result of historically low-interest rates worldwide -- notes in Japan, Germany and France have negative yields -- as well as what skeptics see as investors’ complacency as they pour into index-based funds without scrutinizing their holdings.

“I’m guessing the alarm bells are ringing, and in many ways it feels like 2007,” said Anders Faergemann, a senior fund manager in London at PineBridge Investments, which oversees about $80 billion globally.

“Dedicated EM investors are dancing ever closer to the exit door, but for those of us who were around in 2007 there was a long period in which EM continued to rally even though valuations were stretched.”

However, as Bloomberg notes, the Federal Reserve’s hawkish posture last week sets the stage for an uptick in developing-nation volatility in the second half of the year, Bank of America Merrill Lynch strategists said.

And then there is the lagged effect of the collapse in China's credit impulse - set to send volatility and risk spreads higher...

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Low market volatility spurred a “torrent” of capital flows into emerging-market debt, reflecting investor complacency and “excessive risk taking,” Bank of America Merrill Lynch strategists led by David Hauner in London wrote in a report last week. He warned that the second half of the year should bring challenges for lower-rated issuers as higher interest rates in the U.S. reduce some of the appeal of junk credits with relatively steep interest rates.

“The market is at a point where we haven’t hit a real bump in the road to wake everyone up.”

And now, as Bloomberg reports, Emerging-market debt funds had a phenomenal first half of 2017, with record inflows and solid returns. But the ebullience is running out of steam and that sentiment will most likely deteriorate even further in the weeks to come.

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In the past week, investors withdrew $826.8 million from the biggest emerging-market debt exchange-traded fund, the largest withdrawals in the $11.5 billion fund's history. Hard-currency debt of developing nations and their companies have lost more than 1 percent since June 26, when benchmark borrowing costs in Europe and the U.S. surged.

However, as Deutsche Bank's Gautam Kalani and Hongtao Jiang note overall inflows into both EM equity and debt, that were strong in the first half of the year, slowed "markedly" last week...

The fickel flows into, and now rushing out of, EM debt, seem to have finally woken up to the reality that, as Bloomberg's Lisa Abramowicz notes, the fundamental health of emerging markets has deteriorated on average, with the debt of lower-rated countries such as Turkey, Ecuador and Sri Lanka accounting for a greater proportion of benchmark indexes. As Bloomberg Intelligence's Damian Sassower and Alexander Graf noted in a recent research note, leverage is on the rise among high-grade, nonfinancial corporate and quasi-sovereign issuers in emerging markets. And investors are getting compensated less for the increasing debt relative to income of these issuers.