Monday, August 26, 2013

Emerging Market Debt: A Side Effect of the Fed’s Policies

Emerging Market Debt: A Side Effect of the Fed’s Policies

Whether it’s this month, next quarter, or next year, the Federal Reserve is going to raise short-term interest rates and stop buying and then start selling long-term bonds.  We’ve known that this day would come ever since the Fed first took these actions.  The Fed’s purpose, of course, was to drive down interest rates in order to help stimulate the economy.  However, the Fed’s medicine had side effects, and we’re seeing one play out right now.
High Yield Update (1999)
With interest rates at near zero, some hedge funds decided to borrow money in the US and invest in bonds in emerging markets, such as India, Brazil, and Turkey.   They saw an opportunity to earn substantially higher yields in economies with prospects for rapid growth.  Modest amounts of capital went into various local businesses and projects and helped to further stimulate the emerging economies.  The Chinese identified many of the same markets as good places to make direct investments and tie up strategic resources. So far so good. 

Those early investors generated very attractive returns. First, they enjoyed high yields on their original investment.  Second, they began to generate capital gains as interest rates moderated in the emerging markets on the backs of additional waves of investors clamoring to get in on the action.  Moreover, the early investors figured they were protecting themselves by spreading their investments across numerous countries and by making the loans in US dollars rather than local currencies.

Once a year or so of attractive returns were clearly visible, retail mutual funds and large institutional investors such as public pension plans decided to follow the hedge funds into the emerging market.  By now the yields weren’t as high, but they were still more attractive than US Treasuries or corporate bonds.  In the first year or two, US retail and institutional investors generated decent gains and kept pushing more capital into the emerging markets.  Local business people were all too happy to take the capital and put it into projects.  However, the flow of dollars had gone from a stream to a torrent, and far too much capital was flowing into economies that could not productively absorb it. 

The seeds of a rout had been firmly established.  First, many emerging economies began to become more synchronized.  The huge flows of American as well as Chinese capital were overwhelming the productive capacity of emerging economies across the globe.  Second, inflationary pressures were beginning to build and local currencies started to fall.  Third, the Federal Reserve, the pump behind this expansion, gave the first hints that it was going to pull back.   Fourth, monetary authorities in many emerging market jurisdictions began to raise interest rates in order to defend their currencies and stanch inflation.  Fifth, China began to pull back as its economy slowed, and its need to retain capital inside China increased.  Finally, some US investors started to sell their emerging market bonds, putting additional upward pressure on emerging market interest rates and downward pressure on their currencies.

The local business people who had readily accepted the debt investments from foreign investors began to face a huge amount of pressure.  While they did business in their local currency, they owed investors in US dollars.  So as their local currency fell, the cost of servicing the debt kept climbing.  Since many of the projects they undertook had been excessively large, the projects failed to produce sufficient returns.  In other words, credit risk was rising, which in turn, drove emerging market interest rates higher yet.

The net result is that the retail investors and large institutions who came to the emerging markets late and overstayed their welcome are likely to suffer fairly substantial losses as they try to pare their large positions.  What they thought was a US dollar denominated investment is going to wind having substantial exposure to foreign currency.  What they believed were a series of investments in a diverse set of economies is going to result in a series of investments that are largely synchronized.   The investment gains of the last couple of years will probably be erased.

As emerging market debt becomes distressed, the smartest of the hedge funds will buy up the bonds as distressed securities and make some quick money.  Their returns will attract notice from public pension plans and retail mutual funds, and another cycle will play out as distressed debt replaces emerging market debt as the hot investment sector.

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