Thursday, June 26, 2008

Bonds Up In Smoke

Put a Fork in These Bonds — They're Done
The world's best performing fixed-income index since 1992 is now stuck in a rut. And as stagflation concerns continue to mount in the emerging markets, returns are likely to turn negative for the first time since 1998.The J.P. Morgan Emerging Markets Bond Index has outpaced the returns generated by all other debt markets over the last 15 years. Emerging market debt has also outpaced the S&P 500 Index since 1993 and many other industrialized economy stock markets. Over the last several years, emerging market countries have benefited from shrinking credit spreads, or interest rate differentials between emerging market bonds and risk-free Treasury bonds. The largest emerging markets, like Russia and Brazil, benefit enormously from rising commodities prices. Others, including China and India, have also gotten a boost from the export boom driven by low wages. But with growing inflation concerns, especially in Asia, investors are starting to redeem all their funds that are tied to emerging markets.According to Emerging Portfolio Fund Research, the appetite for global bond funds continues to fall off a cliff. For the week ending June 20, emerging market bond funds suffered from growing jitters about rising inflation in Turkey, Russia, China, and Argentina. In Asia, consumer prices are now in excess of 7.5% — their highest rate in 9 ½ years. Also, many emerging market economies are now overheating as central banks combat rising inflation with rate hikes. Rising interest rates, combined with growing inflation, depresses bond prices. Despite the increasing redemptions in 2008 from individual investors, credit spreads remain historically low. The benchmark J.P. Morgan Emerging Markets Bond Index is yielding just 2.88% more than 10-year Treasury bonds. Over the last 12 months, emerging market debt has gained 5.9% compared to 12.6% for 10-year T-bonds. But this year, the asset class is down 1.6% as inflation and rising rates knock prices lower. With the exception of high-grade corporate debt in the United States and in Europe, you should avoid the majority of fixed-income markets in a growing environment of toxic inflation in food and energy prices. Many emerging market central banks will be forced to raise rates even higher this year. That will be bad news for stocks and bonds. For now at least, it looks like the big post-2002 bull market for emerging market assets is finally over. It won't resume until governments lick inflation.

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