Wednesday, June 1, 2011

Emerging Market Inflation Indexed Bonds

This is an older article but one that I believe is highly relevant. Inflation indexed bonds are typically thought of as US government treasury TIPS. But other countries are beginning to follow that trend by issuing their own inflation indexed debt. Specifically, emerging market investors remain eager to retain exposure to the sector but many are beginning to voice fears about inflation. Many emerging markets, such as Indonesia, have lost the old stigma of political instability and now have yields priced at or lower than Western European countries. But these yields are not protected or indexed to inflation. Food and fuel remain the largest and most volatile segments of most EMs' indices. The hawkish stance taken by many EM central bankers is eating into investor returns.

However, clouds loom on the horizon. Not all EM's are the same. The demographic dividends of some nations such as India and China are expiring. Wage inflation, briefly mentioned in other posts here, continues to rise. Turnover rates at Indian and Chinese firms is approaching 50%/year. The cost of training, hiring, and retaining workers is prohibitive - particularly when their clients in Western Europe and North America are largely unsupportive of price hikes. There will come a time when this slope of diminishing returns hits a wall of worry and economic growth cool down (my own belief is within the next 9-16 months). At that point, EM central banks may be forced to take a more dovish stance - including interest rate cuts.

The Bottom Line: EM are beginning to offer inflation indexed bonds to investors worried about rising food and fuel prices eating into their returns. The trick however is to buy at a time when they believe real rates will come down.
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