Euro zone’s very own “emerging markets”

Friday, 22 October 2010 03:28 -     - {{hitsCtrl.values.hits}}

 LONDON, (Reuters) - With a sudden and insatiable global investment demand for all things emerging markets fast becoming a crowded trade, many investors are being tempted to seek out the next best thing -- high-yielding euro zone debt.

Fear of more money printing and passive devaluations in the United States, Japan and possibly Britain have in recent weeks stampeded the investment herd toward the higher yields and rising currencies of developing economies.

 But as the search for yield and rising currency ratesbecomes indiscriminate, there’s been a growing case for hoovering up the juicy returns on offer in the euro zone’s debt-battered periphery of Greece, Ireland, Portual and Spain.

 Are these the euro zone’s very own “emerging markets”?

 Just look at 10-year yield premia over both “core” U.S. and German debt -- more than 600 basis points for Greece, almost 400 basis points for Ireland, more than 300 basis points for Portugal and more than 150 basis points for Spain.

 Big risks, no doubt, the fallout from fiscal austerity and the lingering threat of debt default chief among them.

 But there remains a political commitment not to restructure member states’ debts, and the Spring crisis saw the introduction of a 440 billion euro safety net -- the European Financial Stability Facility -- to back that pledge at least until 2013.

And that is on top of Greece’s emergency financing package from the International Monetary Fund and European Union.

 Few emerging markets have that sort of support, and yet equivalent benchmark emerging market dollar bonds, illustrated by JPMorgan’s EMBI+ index, have equivalent yield premia of just 255 basis points. Local currency emerging sovereign bond benchmarks return just over 600 basis points.

 Currency direction is always a wild card, but many investors have scrambled for local currency debt in emerging markets to position for a protracted revaluation as the dollar is undermined by more quantitative easing. Yet with many emerging countries, such as China, operating dollar currency pegs, the free-floating euro has been among the biggest gainers.

 With the European Central Bank institutionally barred from joining the money-printing club for now, the euro has been caught in the crossfire of a battle to keep currency rates low.

 Europe’s single currency, battered earlier this year by the existential euro government debt crisis, has accelerated more than 10 percent higher against the dollar since the Federal Reserve flagged the prospect of so-called QE2 -- its second wave of quantitative easing via bond and asset buying.

 Add that currency gain to the high yields now on offer for holding the bonds of debt-laden governments on the periphery of the 12-nation euro bloc and you get some interesting numbers.

 Since Fed chief Ben Bernanke’s speech at the Jackson Hole central banking forum on Aug. 27 stoked QE2 speculation, total returns on 10-year Greek government debt in euro terms are up almost 20 percent.

 But if you were a dollar-based fund manager in Boston, for example, your currency-enhanced returns on the same debt would have topped 30 percent in that six-week period alone.

Strategists argue that many funds may still be prevented by risk managers from buying peripheral euro zone debt following the ructions of early 2010. But public and private funds with deep pockets or hedge funds with nimble market timing have more scope to take advantage of such outsize returns.

 Largely for political and strategic reasons, China’s Premier Wen Jiabao this month offered to buy Greek government bonds when Athens resumes issuance, adding that it wanted to boost shipping and trade ties with Athens.

 China has already spent around 420 million euros buying Spanish and Greek bonds this year, according to estimates from EU trade commissioner Karel De Gucht.

 Norway’s sovereign wealth fund, the world’s second largest, with assets over $470 billion, has reportedly bought Greek government bonds. Azerbaijan’s SWF, 40 percent of whose assets are in euro zone fixed income, has also voiced support.

 Yet it’s not just these big public-sector behemoths who have been buying.

 Dan Fuss, who as vice chairman of Loomis Sayles helps manage

some $150 billion of assets, said last week the firm has been buying Irish government debt aggressively in recent weeks at auction and on the secondary market -- mainly for its attractive yield and “very decent” credit quality.

 “The worries about Ireland are valid, but the credit over time -- and I don’t mean in the next 27 days or so -- is actually very decent,” Fuss said