Last year was one of the most successful for international bond investors in many years, but that that is starting to change as the end of quantitative easing (QE) is already apparent and political risks are rising for issuers like Russia.

The systematic winding down of QE programmes by global regulators hasn’t been able to change investors’ positive attitude towards emerging markets (EM) assets. That was driven by the macroeconomic backdrop and the high-risk appetite on the part of investors thanks to the low yield environment, which combined to create record breaking activity in the Eurobonds primary markets.

Despite this, since the start of 2018 the game has begun to change. The growth of the yields in the US and a revaluation of credit risk premiums has offset the ongoing economic growth in emerging markets. Volatility is on the rise again, but activity in the primary market has remained at a high level. All taken together that means the windows of opportunity for issuers are starting to narrow.

The end of QE

Excessive liquidity has been driving the growth of EMs in the last few years. Investors from developed markets in search of yield willingly took on extra credit risks. In spite of the intentions to withdraw, regulators were in no hurry to hike rates and bring QE to an end. At the European Central Bank (ECB), Bank of England and Bank of Japan interest rates remained at their historical low and large asset purchase programmes continue. Only the US Federal Reserve has been gradually changing its monetary policy. The US regulator increased the federal funds rate three times in 2017, and from October it also started a programme to wind down its position in the bond market, reducing its securities portfolio.

However, the Fed’s actions have not impacted the markets yet because of the slow place of the change. Market participants were not interested in the tightening of monetary policy as such, but in how quickly it would be implemented.

Dynamics of FRS rate, 3M LIBOR USD and UST 10Y YTM, %

Source: Cbonds.ru

The recent US tax reform launched by the Trump administration doubled the country’s budget deficit in 2018, which led the US Treasury Department to enter the market with a record borrowing plan. And the increase in the offer of treasury securities at weekly auctions has led to a significant withdrawal of dollar liquidity from the market.

Since the start of this year the Fed has continued to tighten monetary policy. The federal funds rate was raised in March and may be raised two or three more times during the year, leading to rapid growth in US treasury securities yields. The yields on the ten-year Treasury bills (UST 10Y) have risen to a ten year high of almost 3%.

Rising borrowing costs and falling liquidity are reflected in the rates being charged on the interbank market: the three month Libor USD rate has grown by 62bp since the beginning of the year and reached 2.32% in April. These facts indicate that the QE era for the dollar seems is coming to an end.

While QE winds down in the US, the Europeans are further behind. The ECB announced last year that its €30bn a month asset purchase programme would continue until September 2018.

It is unlikely that the ECB, Bank of England or Bank of Japan will raise rates anytime soon. Excessive liquidity from Europe and Japan continues to support debt markets. However, it is already apparent that current market conditions are drastically different this year from those in previous years.

A “new normal” is gradually asserting itself in the international capital markets.

The increase in US Treasury securities yields has led to an overestimation of the attractiveness of premiums by investors in emerging markets. This has resulted in the increase in the capital flow into dollar bonds with higher credit quality, which has started to provide conservative investors with an acceptable level of yields. That could be bad news for EM investors and issuers. According to the Institute of International Finance (IIF), net capital outflow from EM assets-oriented funds amounted to $4.5bn billion in February alone.

Dynamics of yields to maturity of EM sovereign Eurobonds, Euro–Cbonds indices, %

Source: Cbonds.ru

Despite an upbeat macroeconomic story in EMs, the falling demand for their Eurobonds is driving up the yields of Eurobonds in emerging markets.

The yields of sovereign Eurobonds from Eastern Europe have grown by 64bp since the beginning of the year, from Africa by 49 bp, and from Asia by 44 bp. JPMorgan’s global EM bond (TR) index has decreased by 2.3% this year after the total yield grew by 9.1% in 2017.

Falling demand will put more pressure on the market as a significant volume of bonds mature in the mid-term and will be more difficult to refinance.

The volume of debt obligations that must be repaid in the course of just the next two years amounts to $513bn. Issuers will be forced to enter the market with new issues to refinance outstanding debts.

Due to the decrease in demand for new issues these will have to be issued at a premium to the prevailing market rates. Thus, in the foreseeable future we may see Eurobonds yields in EMs continue to grow, while at the same time the level of activity in the primary market will remain high.

Planned EM Eurobonds repayments

Source: Cbonds.ru

The ratio of probability of default to yield to maturity of 10-year Eurobonds of sovereign EM issuers

Source: Cbonds.ru