## 0503 - Section 1 & Section 2 ## Source details **Canonical URL:** [0503 - Section 1 & Section 2](https://www.imf.org/-/media/files/publications/fmu/0503.pdf) ## Other formats - [Markdown version](/-/media/files/publications/fmu/0503.pdf.md) - [Structured JSON version](/-/media/files/publications/fmu/0503.pdf.json) --- ### Liquidity, search for yield, and credit spreads - Ample liquidity in main financial centers and improved market confidence spurred a rally in corporate and emerging market bonds through mid-May. - The search for yield contributed to compression of credit spreads across mature and emerging bond markets since the peaks of October 2002. - 5-year averages (bps): - High Yield: 625 - EMBI+: 844 - Investment Grade: 75 - Higher-yielding currencies appreciated year-to-date, reflecting a flow of funds to local markets. - Policy interest rates and government bond yields in Europe, Japan, and the United States expected to remain unusually low, effectively reducing financing costs and encouraging a reduction in investors’ cash positions. - Substantial inflows into high-yield and emerging market mutual funds in 2003 and increased allocations by institutional investors to emerging market bonds as an asset class. ### Drivers and risks to the rally - Fundamental factors supporting the rally: - Progress in corporate balance sheet repair in the United States. - Marked change in investor attitude toward prospects for reform in Brazil. - Credit default spreads narrowed substantially across virtually all mature and emerging market sectors. - Positive developments since March 11: - Strong rebounds in U.S. and European equity markets. - Moderation of spot and future oil prices following the end of the war in Iraq. - By April 2003, falling credit spreads, strengthening high-yielding currencies, and declining implied volatilities pushed indicators of risk appetite to record high levels; since end-April, risk appetite waned mainly due to increased implied volatility in currency markets. - Key investor concerns: - Risk of U.S. dollar overshooting (fall to four-year lows against the euro). - Uncertain prospects for global growth, corporate earnings, and mature equity markets. ### Major bond and money markets: growth and inflation expectations - Markets pricing in sub-par growth and limited inflationary pressure in the euro area, the United Kingdom, and the United States; yield curves have fallen across the maturity spectrum so far in 2003. - Futures contracts suggest market expectations for further central bank easing this year, with short-term rates priced to rise thereafter. - Real yields on inflation-indexed bonds in the euro zone, the United Kingdom, and the United States remain low despite an increase in mid-March after the end of the war in Iraq. - Market expectations for inflation (proxied by the spread between real yields on inflation-indexed government bonds and nominal yields) continue to suggest limited inflationary pressure; in most cases, expectations for future inflation are below currently prevailing inflation rates. - Japan: - Tenacious deflationary pressures and Bank of Japan policies have kept government bond yields at virtually zero for maturities of three years or less. - 10-year bond yields reduced to less than 60 basis points. - 30-year yields fallen to about 1 percent. ### Equity markets, corporate fundamentals, and earnings - European and Japanese equity markets declined so far in 2003; U.S. equities showed only modest gains, with a strong mid-March rally after the end of the war in Iraq. - U.S. first-quarter S&P 500 outcomes: - Profit growth of 12.9 percent (year-on-year). - Revenue growth of 9.8 percent. - Ongoing U.S. corporate balance sheet repair has resulted in a substantial reduction in short-term debt and a substantial rise in corporate cashflow, supporting perceptions of lower corporate default risk and sustaining rallies in corporate bonds, especially high-yield. - Rising corporate credit quality has tended to precede improvement in corporate earnings, implying the prospect of continued earnings growth if the economy is supportive. - U.S. equities appear reasonably valued relative to bonds owing largely to historic low yields on U.S. treasuries; the earnings yield ratio reflects past earnings rather than expected earnings, so sustained earnings growth is needed to underpin valuations. ### Emerging markets: issuance, investor flows, and valuation risks - Through mid-May 2003, emerging markets had raised $48.8 billion in gross funding in the international capital markets. - First-quarter 2003 issuance dynamics: - Bond issuance strong in January, weakened during the Iraq war, and accelerated after the war. - Syndicated loan commitments low as international banks continued to withdraw. - Equity placements virtually dried up. - Cumulative gross issuance of bonds, loans, and equities by emerging markets through mid-May 2003 lagged previous years. - Q1 2003 sovereign bond placements accounted for $13.8 billion, roughly two thirds of total bond issuance; sovereign issuance in Q1 broadly in line with average levels for the same period over the past five years. - Many governments have already achieved their 2003 financing targets, although some have not, notably Brazil, Turkey and the Philippines. - Equity issuance in Q1 2003 totaled $1.2 billion, significantly below recent years. - Syndicated lending by international banks remained weak in Q1 2003, with continued discrimination according to credit quality; roughly two thirds of financing in the quarter was extended to investment-grade credits. - Inclusion of collective action clauses (CACs) in sovereign emerging bond issues gained momentum in 2003; Mexico and Brazil issued global bonds with CACs; South Africa issued a global bond under New York law with CACs; Uruguay’s debt swap bonds included CACs. These issues were well received and heavily oversubscribed. ### External environment, investor behavior, and valuation concerns - The global quest for yield, amid accommodative policies in major financial centers, created a positive external environment for emerging market bonds; flows into the secondary emerging bond market were strong. - Emerging market bond prices buoyed by favorable external conditions and changed investor attitudes toward Brazil; higher-yielding emerging market credits—particularly Brazil—performed especially strongly. - Secondary market support also came from high interest and amortization payments. - Spreads have narrowed considerably and in many cases are well below historical averages, suggesting that valuations have become stretched. - Structural shift toward fixed-income investments by institutional investors (notably U.S. and European pension funds) is supporting demand for emerging market bonds because of bond-like liabilities, attractive risk-adjusted returns, and low correlations with other asset classes. - Retail investors and cross-over fund managers chased high returns in corporate and emerging bond markets; cross-over flows likely to reverse more quickly than new dedicated institutional mandates, with reversals likely to affect high-grade emerging market bond prices most. - Increased participation of hedge funds noted, especially in the sub-investment-grade sector, but leverage and position sizes remain well below pre-1998 levels. ### Emerging market bond rally and investor inflows (Section 2 highlights) - Net inflows to U.S. mutual funds have supported a rally in high-yielding assets, including emerging market bonds. - The EMBI+ has gained 17 percent through May 15. - Led by higher-yielding credits, emerging market bonds have outperformed most market participants’ return expectations for the year. - High-yielding credits in Latin America led the rally; Brazil, Ecuador, and Nigeria were the top performing credits year-to-date, with Argentina also performing strongly. Turkish and Venezuelan bonds lagged the broader market despite high yields. - Total bond payments for EMBIG & EMBIG Euro include coupon and amortization due throughout the year, supporting secondary market liquidity. ### Spread compression and valuation (Section 2) - The EMBI+ spread narrowed to 574 basis points from a high of 1,040 basis points last year. - In the current seven-month rally, the EMBI+ spread declined by about 600 basis points, compared with an average decline of 220 basis points over a similar time frame in three previous rallies. - Spreads on many emerging market bonds are near record lows; the non-Latin American component of the EMBI+ is approaching its all-time low. - Spreads are more than one standard deviation below their long-term means for 11 of the 18 constituents of the EMBI+ (excluding Argentina). - Spreads exceed long-term means only for the Philippines, Turkey, and Venezuela. - Triple-B Mexican bonds are trading barely above equivalently rated U.S. corporate counterparts (as of May). - The spread between Brazil and a single-B U.S. corporate is 224 basis points. ### Fundamentals, credit quality, and issuance dynamics (Section 2) - Emerging market credit quality (average across EMBI Global constituents weighted by index weights) has improved by one notch since 1997. - Improvements reflect increased adoption of flexible exchange rate regimes, buildup of foreign exchange reserves, and a decline in external indebtedness driven largely by reduced bank financing. - Emerging market issuance has been readily accommodated, but there are signs of froth, including issuance by some second-tier Russian corporates. - Emerging markets remain prone to wide swings in spreads, often arising from overzealous issuance when investor appetite is strong. ### Country-specific developments and capital flows (Section 2) - Brazil: - Improved investor sentiment tied to prospects for the structural reform agenda and strong external and fiscal accounts has buoyed markets. - Appreciation of the real has been attributed to raising of short-term financing by corporates and banks, while longer-term capital flows have remained subdued. - Foreign direct investment (FDI) flows to Brazil have fallen this year, in part owing to slow economic growth and investor uncertainty over regulatory and pricing policies. - Vulnerabilities are masked at times by inflows; past flows have temporarily masked vulnerabilities and led to complacency in implementing needed reforms. ### Risks, scenarios, and macro linkages (Section 2) - Risks to the favorable outlook: - Deterioration in the external environment or a reversal in a major emerging market economy. - Profit taking or a reassessment of risk premiums if spreads have compressed too far. - A prolonged slowdown in global growth that would erode emerging market fundamentals and potentially reduce foreign direct investment. - Rising interest rates on government bonds in mature markets or improved sentiment toward equities in the United States and Europe that could attract flows away from emerging market bonds. - Overambitious emerging market issuance triggering a sell-off. - Further credit rating downgrades across dollarized economies following changes in Moody’s ratings methodology; the Dominican Republic, Peru, and Turkey are among countries that could be affected. - Differential effects of higher U.S. yields: - An increase in U.S. treasury yields in the context of improved growth prospects would likely affect high-grade emerging market bonds more than high-yielding counterparts, given the limited yield cushion on high-grade emerging market bonds. - Conversely, higher U.S. interest rates accompanied by expectations of stronger global growth could lead to further spread compression for high-yield emerging market bonds. - Currency and dollar risks: - The U.S. dollar has fallen to a four-year low against the euro. - Rising implied volatilities on currency options reflect investor concerns over the dollar. - Foreign ownership shares of U.S. assets: - 32 percent of U.S. treasuries are foreign-owned. - 21 percent of corporate bonds are foreign-owned. - 12 percent of agency securities are foreign-owned. - 12 percent of equities are foreign-owned. - A deterioration in sentiment toward U.S. assets could lead the dollar to decline, undermine activity in the euro area and Japan, and raise U.S. real yields, damping growth. ### Policy implications and recommendations (Section 2) - Emerging market countries should avoid complacency and pursue policies aimed at securing medium-term sustainability, including measures to improve the structure of public sector debt. - Sustaining improvements in credit quality and financial strength requires stronger global economic growth. - Vigilance is warranted regarding issuance practices to avoid overambitious supply that could trigger a market reversal. - Monitor dollar dynamics and foreign investor sentiment given their potential to rapidly affect global flows and emerging market valuations. *Financial Market Update May 2003, International Capital Markets Department, International Monetary Fund.* ### Section 1 ### 0503 - Section 1 ### Liquidity, search for yield, and credit spreads - Ample liquidity in main financial centers and improved market confidence spurred a rally in corporate and emerging market bonds through mid-May. - The search for yield has contributed to compression of credit spreads across mature and emerging bond markets since the peaks of October 2002. - 5-year averages (bps): - High Yield: 625 - EMBI+: 844 - Investment Grade: 75 - Higher-yielding currencies appreciated year-to-date, reflecting a flow of funds to local markets. - Policy interest rates and government bond yields in Europe, Japan, and the United States expected to remain unusually low, effectively reducing financing costs and encouraging a reduction in investors’ cash positions. - Substantial inflows into high-yield and emerging market mutual funds in 2003 and increased allocations by institutional investors to emerging market bonds as an asset class. ### Drivers and risks to the rally - Fundamental factors supporting the rally: progress in corporate balance sheet repair in the United States and a marked change in investor attitude toward prospects for reform in Brazil. - Credit default spreads narrowed substantially across virtually all mature and emerging market sectors, pointing to a widespread improvement in market assessments of credit quality. - Positive developments since March 11: strong rebounds in U.S. and European equity markets; moderation of spot and future oil prices following the end of the war in Iraq. - By April 2003, falling credit spreads, strengthening high-yielding currencies, and declining implied volatilities pushed indicators of risk appetite to record high levels; since end-April, risk appetite waned mainly due to increased implied volatility in currency markets. - Key investor concerns: the risk of U.S. dollar overshooting (fall to four-year lows against the euro) and uncertain prospects for global growth, corporate earnings, and mature equity markets. ### Major bond and money markets: growth and inflation expectations - Markets pricing in sub-par growth and limited inflationary pressure in the euro area, the United Kingdom, and the United States; yield curves have fallen across the maturity spectrum so far in 2003. - Futures contracts suggest market expectations for further central bank easing this year, with short-term rates priced to rise thereafter. - Real yields on inflation-indexed bonds in the euro zone, the United Kingdom, and the United States remain low despite an increase in mid-March after the end of the war in Iraq. - Market expectations for inflation (proxied by the spread between real yields on inflation-indexed government bonds and nominal yields) continue to suggest limited inflationary pressure; in most cases, expectations for future inflation are below currently prevailing inflation rates. - Japan: tenacious deflationary pressures and Bank of Japan policies have kept government bond yields at virtually zero for maturities of three years or less; 10-year bond yields reduced to less than 60 basis points and 30-year yields fallen to about 1 percent. ### Equity markets, corporate fundamentals, and earnings - European and Japanese equity markets declined so far in 2003; U.S. equities showed only modest gains, with a strong mid-March rally after the end of the war in Iraq. - U.S. first-quarter S&P 500 outcomes: profit growth of 12.9 percent (year-on-year) and revenue growth of 9.8 percent. - Ongoing U.S. corporate balance sheet repair has resulted in a substantial reduction in short-term debt and a substantial rise in corporate cashflow, supporting perceptions of lower corporate default risk and sustaining rallies in corporate bonds, especially high-yield. - Rising corporate credit quality has tended to precede improvement in corporate earnings, implying the prospect of continued earnings growth if the economy is supportive. - U.S. equities appear reasonably valued relative to bonds owing largely to historic low yields on U.S. treasuries; the earnings yield ratio reflects past earnings rather than expected earnings, so sustained earnings growth is needed to underpin valuations. ### Emerging markets: issuance, investor flows, and valuation risks - Through mid-May 2003, emerging markets had raised $48.8 billion in gross funding in the international capital markets. - First-quarter 2003 issuance dynamics: bond issuance strong in January, weakened during the Iraq war, and accelerated after the war; syndicated loan commitments low as international banks continued to withdraw; equity placements virtually dried up. - Cumulative gross issuance of bonds, loans, and equities by emerging markets through mid-May 2003 lagged previous years. - In Q1 2003 sovereign bond placements accounted for $13.8 billion, roughly two thirds of total bond issuance; sovereign issuance in Q1 broadly in line with average levels for the same period over the past five years. - Many governments have already achieved their 2003 financing targets, although some have not, notably Brazil, Turkey and the Philippines. - Equity issuance in Q1 2003 totaled $1.2 billion, significantly below recent years. - Syndicated lending by international banks remained weak in Q1 2003, with continued discrimination according to credit quality; roughly two thirds of financing in the quarter was extended to investment-grade credits. - Inclusion of collective action clauses (CACs) in sovereign emerging bond issues gained momentum in 2003; Mexico and Brazil issued global bonds with CACs; South Africa issued a global bond under New York law with CACs; Uruguay’s debt swap bonds included CACs. These issues were well received and heavily oversubscribed. ### External environment, investor behavior, and valuation concerns - The global quest for yield, amid accommodative policies in major financial centers, created a positive external environment for emerging market bonds; flows into the secondary emerging bond market were strong. - Emerging market bond prices buoyed by favorable external conditions and changed investor attitudes toward Brazil; higher-yielding emerging market credits—particularly Brazil—performed especially strongly. - Secondary market support also came from high interest and amortization payments. - Spreads have narrowed considerably and in many cases are well below historical averages, suggesting that valuations have become stretched. - Structural shift toward fixed-income investments by institutional investors (notably U.S. and European pension funds) is supporting demand for emerging market bonds because of bond-like liabilities, attractive risk-adjusted returns, and low correlations with other asset classes. - Retail investors and cross-over fund managers chased high returns in corporate and emerging bond markets; cross-over flows likely to reverse more quickly than new dedicated institutional mandates, with reversals likely to affect high-grade emerging market bond prices most. - Increased participation of hedge funds noted, especially in the sub-investment-grade sector, but leverage and position sizes remain well below pre-1998 levels. *Financial Market Update May 2003, International Capital Markets Department, International Monetary Fund.* ### Section 2 ### 0503 - Section 2 ### Emerging market bond rally and investor inflows - Net inflows to U.S. mutual funds have supported a rally in high-yielding assets, including emerging market bonds. - The EMBI+ has gained 17 percent through May 15. - Led by higher-yielding credits, emerging market bonds have outperformed most market participants’ return expectations for the year. - High-yielding credits in Latin America led the rally; Brazil, Ecuador, and Nigeria were the top performing credits year-to-date, with Argentina also performing strongly. Turkish and Venezuelan bonds lagged the broader market despite high yields. - Total bond payments for EMBIG & EMBIG Euro include coupon and amortization due throughout the year, supporting secondary market liquidity (Figure referenced). ### Spread compression and valuation - The EMBI+ spread narrowed to 574 basis points from a high of 1,040 basis points last year. - In the current seven-month rally, the EMBI+ spread declined by about 600 basis points, compared with an average decline of 220 basis points over a similar time frame in three previous rallies. - Spreads on many emerging market bonds are near record lows; the non-Latin American component of the EMBI+ is approaching its all-time low. - Spreads are more than one standard deviation below their long-term means for 11 of the 18 constituents of the EMBI+ (excluding Argentina). - Spreads exceed long-term means only for the Philippines, Turkey, and Venezuela. - Triple-B Mexican bonds are trading barely above equivalently rated U.S. corporate counterparts (as of May). - The spread between Brazil and a single-B U.S. corporate is 224 basis points. ### Fundamentals, credit quality, and issuance dynamics - Emerging market credit quality (average across EMBI Global constituents weighted by index weights) has improved by one notch since 1997. - Improvements reflect increased adoption of flexible exchange rate regimes, buildup of foreign exchange reserves, and a decline in external indebtedness driven largely by reduced bank financing. - Emerging market issuance has been readily accommodated, but there are signs of froth, including issuance by some second-tier Russian corporates. - Emerging markets remain prone to wide swings in spreads, often arising from overzealous issuance when investor appetite is strong. ### Country-specific developments and capital flows - Brazil: improved investor sentiment tied to prospects for the structural reform agenda and strong external and fiscal accounts has buoyed markets. - The appreciation of the real has been attributed to raising of short-term financing by corporates and banks, while longer-term capital flows have remained subdued. - Foreign direct investment (FDI) flows to Brazil have fallen this year, in part owing to slow economic growth and investor uncertainty over regulatory and pricing policies. - Vulnerabilities are masked at times by inflows; past flows have temporarily masked vulnerabilities and led to complacency in implementing needed reforms. ### Risks, scenarios, and macro linkages - Risks to the favorable outlook: - Deterioration in the external environment or a reversal in a major emerging market economy. - Profit taking or a reassessment of risk premiums if spreads have compressed too far. - A prolonged slowdown in global growth that would erode emerging market fundamentals and potentially reduce foreign direct investment. - Rising interest rates on government bonds in mature markets or improved sentiment toward equities in the United States and Europe that could attract flows away from emerging market bonds. - Overambitious emerging market issuance triggering a sell-off. - Further credit rating downgrades across dollarized economies following changes in Moody’s ratings methodology; the Dominican Republic, Peru, and Turkey are among countries that could be affected. - Differential effects of higher U.S. yields: - An increase in U.S. treasury yields in the context of improved growth prospects would likely affect high-grade emerging market bonds more than high-yielding counterparts, given the limited yield cushion on high-grade emerging market bonds. - Conversely, higher U.S. interest rates accompanied by expectations of stronger global growth could lead to further spread compression for high-yield emerging market bonds. - Currency and dollar risks: - The U.S. dollar has fallen to a four-year low against the euro. - Rising implied volatilities on currency options reflect investor concerns over the dollar. - Foreign ownership shares of U.S. assets heighten overshooting risk: 32 percent of U.S. treasuries, 21 percent of corporate bonds, 12 percent of agency securities, and 12 percent of equities are foreign-owned. A deterioration in sentiment toward U.S. assets could lead the dollar to decline, undermine activity in the euro area and Japan, and raise U.S. real yields, damping growth. ### Policy implications and recommendations - Emerging market countries should avoid complacency and pursue policies aimed at securing medium-term sustainability, including measures to improve the structure of public sector debt. - Sustaining improvements in credit quality and financial strength requires stronger global economic growth. - Vigilance is warranted regarding issuance practices to avoid overambitious supply that could trigger a market reversal. - Monitor dollar dynamics and foreign investor sentiment given their potential to rapidly affect global flows and emerging market valuations. --- _Source: https://www.imf.org/-/media/files/publications/fmu/0503.pdf_