The escape route from risky peripheral euro zone debt into higher-yielding emerging markets is becoming increasingly tortuous, as the debt crisis marries the performance of all assets closer together.
Frontier debt traditionally appeals to institutional funds because of the opportunities it provides for diversification. But as risk aversion grows and liquidity falls, this is no longer happening.
Several exotic emerging market borrowers have launched bonds this year, just when countries like Greece and Italy have suffered multiple ratings downgrades and spiraling yields, freezing them out of international capital markets.
Emerging markets at first kept some distance from the events of the euro zone, but global fear of risk has removed that disconnect. As stress rises worldwide, the investment community is selling indiscriminately.
Fund managers and analysts point to some investment opportunities among Gulf borrowers, African sovereigns or the off-shore Chinese renminbi bond market, but choices are becoming increasingly limited.
The number of our 'buy' recommendations is probably the lowest we have ever had on the sovereign side, said Gabriel Sterne, economist at frontier markets brokerage Exotix, which specializes in higher-yielding emerging market debt.
Even high-risk funds are still waiting for the bottom.
Investors across the world have pulled out of euro zone debt and generally have shifted toward safe havens such as U.S. Treasuries or gold.
But pension and insurance funds still need to make enough returns to pay out to their pensioners and policyholders, and emerging markets and corporate credit appeared at one time to have filled that gap.
Buying emerging market debt was a good trade earlier this year, when yields were stable and local currencies were strong. Local currency debt funds in particular saw huge inflows, and yields in countries like South Africa reached record lows.
But the tide has turned, particularly since September, when the focus switched to rising yields in Italy, one of the world's largest bond markets.
On Exotix's index of correlation between frontier markets, first measured in 2008, frontier sovereign spreads have never been as correlated as they are at the moment, the broker said in a note.
This means investors are largely turning away from picking out individual borrowers based on local fundamentals. The level of correlation beats even the links between frontier markets during the frenzy after the collapse of Lehman Brothers in Sept 2008.
HSBC's Risk-On Risk-Off (RORO) index, which measures correlations between 34 asset classes in the more liquid developed markets, is at its highest ever.
Emerging market fundamentals are good but the markets do not have liquidity, said Philip Poole, head of investment strategy at HSBC Global Asset Management.
When you have a risk-off trade, people move out of these markets, though that creates entry opportunities.
FINDING A NICHE
The secret for many investors is to look for bonds which are not listed on the major emerging market bond indices.
One example which HSBC favors is the off-shore renminbi debt market -- so-called dim sum bonds. The bank sees the currency as heavily undervalued, and its asset management arm, which has launched renminbi bond funds this year, sees gross issuance of at least 260 billion yuan ($40.78 billion) in 2012 from issuers across the credit spectrum.
An important characteristic of dim sum bonds is that they have not been correlated, there is some degree of diversification, said Poole.
Despite the uncertain climate, borrowers from Gulf countries such as the United Arab Emirates, Qatar and Bahrain have issued or mandated bonds in recent weeks, several of them in the Islamic debt market. Some investors see these as relatively removed from the euro zone worries.
For the really off-index bonds, the correlations are not peaking yet, said Claudia Calich, head of emerging market debt at fund manager Invesco. The fact that UAE, Qatar are off-index seems to be helping them.
Less far from the euro zone troubles are borrowers like Serbia, which issued a dollar bond in recent weeks that immediately fell in price, and is trading with yields close to 8 percent.
Bonds from countries like Belarus, which has suffered severe economic problems this year and where the political climate is uncertain, have also dropped sharply.
But some frontier borrowers, such as African sovereigns Senegal and resource-rich Namibia, have met a better reception.
Namibia has its own story -- it's investment grade, said Calich, who also said secondary bond markets in countries like Argentina and Venezuela were less exposed to events on the world stage.
But for the rest, Calich said:
It's clear all the strong countries within the industrialized space will be correlated. ($1 = 6.3590 Chinese yuan)
(Editing by Stephen Nisbet)