NEW YORK (HedgeWorld.com)–The recent boom in emerging market debt, profitable though it has been for hedge funds and other investors, could be nearing an end.

Performance has been strong. According to the CSFB/Tremont hedge fund index, emerging market funds returned 2.53% in January 2004 and 7.43% over the three months beginning November 2003. That performance is superior to all the other sub-index categories tracked by CSFB/Tremont. At the same time, the spreads on emerging market bonds (i.e. the premiums they pay over the yield of riskless U.S. Treasury bonds) have fallen to seven-year lows. Spreads were at 1,040 basis points in late September 2002, and they had fallen to below 400 basis points by the start of this year.

This situation probably will change in the near future. “It’s likely the rally is coming to a close,” said Charles Gradante, managing principal of Hennessee Group LLC, New York. There will be a widening of the spreads as increased risk is factored in to the yields.

Alternate Scenarios: Bust or Soft Landing

On the other hand, most managers to whom Mr. Gradante has spoken have told him they believe “the widening will be orderly.” There will be no crisis analogous to the one that developed in Southeast Asia in 1997 to 1998. In mid-1997, Thailand devalued its currency, the baht. Currencies in the rest of Southeast Asia soon came under pressure and had to be devalued in their turn. The flow of money into the bonds of those countries stopped, yield spreads soared and shock waves over the following year spread outside of the region, to Brazil and Russia.

A report issued in January by a bankers’ group, the Institute of International Finance Inc., Washington, suggested that analogy when it warned that “there are a number of countries where it is difficult to find justification (based on fundamentals) for either the spread compression that has taken place … or the current low [spread] levels, or both. Ecuador, Venezuela, Peru, Egypt, and the Philippines are ready examples of the former while Poland and Argentina are those for the latter.”

Hennessee itself singled out two trouble spots in a March 8 report that said Brazil’s hesitancy to cut rates due to inflation concerns has frustrated investors and the political instability in Venezuela has added another worry to the region. In the latter country, political opponents of President Hugo Chavez demand his recall, and recent protestors have led to violent confrontations with security forces. Venezuela’s ambassador to the United Nations resigned in protest recently, which ratcheted up the pressure on the Chavez administration.

Following the IIF report, some suggested that there is an analogy between the ongoing rally in EM bonds and the situation in early 1997.

But Jonathan Bayliss, global head for quantitative strategy at J.P. Morgan Chase’s emerging markets research group, London, said this week that he disagrees with such an analogy. “Trading volume by itself doesn’t denote a bubble,” he said. “Hedge funds are actually short EM debt,” and by taking short positions they have helped contain the effects of the enthusiasm of other investors.

In the year ahead, Mr. Bayliss does expect credit in the developed world to tighten. That will have a negative effect on the EM market, “negative in that it reduces liquidity and reduces the amount of money that could potentially buy EM bonds, as well as negative in that it will increase financing costs.” Still, Mr. Bayliss, like Mr. Gradante, expects that the tightening of credit will be gradual and that correspondingly the widening of spreads will be orderly.

CFaille@HedgeWorld.com