Paper Warns of Exodus From Emerging Market Bond Funds

Low interest rates have incited a craze for risky bonds in fast-growing economies, and few fund companies have been more adept in meeting this demand than Pimco, the world’s largest bond manager.

Over the past four years, Pimco’s flagship emerging market local currency fund grew to more than $12 billion from $1.5 billion  as investors, desperate for high-yielding exposure to Brazil, Mexico, Russia and Turkey, showered the fund with cash.

Now, with investors yanking their money out of this and other emerging market bond funds, economists and regulators fear that the result could be a system-rattling “bond market tantrum,” as across the board selling by market heavyweights such as Pimco prompt others to follow suit.

In a paper that will be presented on Friday at a conference in Manhattan,  four influential economists with roots in Wall Street, academia and the Federal Reserve will warn that regulators have to date done little to prepare for such an outcome.

The paper will be discussed by a panel that includes Narayana Kocherlakota,  president of the Federal Reserve Bank of Minneapolis, and Jeremy C. Stein, a governor at the Fed.

“Its the size of these inflows that is unprecedented,” said Hyun Song Shin, a financial economist at Princeton and the incoming head of research at the Bank for International Settlements, the policy and banking outfit based in Basel, Switzerland, that caters to global central banks. “Because the Fed’s policy has been maintained for so long, the pile of firewood has grown to a very large size.”

The notion that a bond market tantrum, if it lasts long enough, can lead to a broader economic crisis that reaches beyond its original locus is not without precedent.

For example, the debt crisis in the euro zone got its start when bond investors began selling Greek government bonds. Before long, Greece, Ireland and Portugal were getting bailed out and viability of the euro was being called into question.

This dynamic was the subject of an influential paper  by the economist Paul de Grauwe, one that many say inspired Mario Draghi, the president of the European Central Bank, to stare the bond vigilantes down by promising to do whatever it takes to guarantee stability in the euro zone.

Whether an investor retreat from these markets starts a brush fire, as was the case last summer and earlier this year, or a wider conflagration remains to be seen. Indeed, there are those who say that the fairly muted effect of the recent emerging market hiccups is proof that the investor exodus need not become a cataclysmic event.

To date, investors have pulled out close to $40 billion from emerging market funds, according to fund tracker EPFR â€" a figure that is fast approaching the $51 billion that left these markets last year. Some of the most pronounced outflows have come from local currency bond funds, which absorbed significant amounts of hot money during the liquidity boom.

During a period when the Turkish Lira, the Brazilian real and the Mexican peso were increasing in value â€" in line with surging economic growth â€" these local currency funds invested in high-yielding government and corporate bonds and became the most popular funds for those seeking a maximum return.

Other debt funds sprouted up as well to meet investor demand, including corporate and hybrid offerings.

“The category has grown very quickly,” said  Michelle Canavan Ward, a mutual fund analyst with Morningstar in Chicago. “Five years ago, there were 30 funds managing less than $10 billion, and now you have 90 funds overseeing $75 billion.”

As currencies like the real and the lira have begun to wobble, the rush for the exit has become all the more hurried. For example, in the past six months, Pimco’s local bond fund has lost about $1.5 billion, reducing its size to $10.7 billion. In the past two months alone, the fund has lost $900 million.

Pimco did not immediately respond to a request for comment.

What worries Mr. Shin and his co-authors is that this selling begets more of the same. Long-term investors, who in theory should act as a counterweight during such periods of panic by buying when others sell, are doing the opposite and heading for safer shores along with the rest of the market.

This fear of “being the last one into a trade” could possibly “set off a race among investors to join a sell-off in a race to avoid being left behind,” the authors of the paper conclude.

In an earlier study, Mr. Shin warned that the most worrying outcome of such a bond market fit would be a credit crisis that could materialize in countries like China, Brazil and Turkey, where private sector borrowing has been most advanced.

Growth in these economies is already slowing down, and Brazil, a charter member of the BRIC club of high-growth nations, may well see economic growth of below 2 percent this year. As investors pull money out of these funds, forcing fund managers to sell Brazilian, Mexican and Chinese bonds, interest rates will shoot up and default rates will increase in number.

In fact, in Pimco’s emerging market corporate bond fund, a more recent offering from the asset manager that has also undergone rapid growth, several companies have either defaulted on their debts or are close to doing so.

They include the Brazilian energy company OGX and the Mexican home builder Hipocetaria su Casita, which are already bankrupt, and the Mongolian Mining Corporation, the coal miner whose bonds have plummeted as it struggles to make its debt payments.

As Mr. Shin and his co-authors point out, there is no regulatory mechanism in place that could, if needed, step in to address such a situation. No doubt, the International Monetary Fund would get involved, but addressing a market panic reaching from Rio de Janeiro to Beijing would be the most complex of tasks.

The solution, they argue, is fairly straightforward: The Fed must remain vigilant in resisting pleas to halt its policy of tapering bond purchases.

“We must stay the course,” Mr. Shin said. “And we should expect choppy market conditions.”