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Both the FT and the WSJ have reported recently on the massive inflows into emerging market bond funds and ETFs. I wrote recently to argue that they don't belong in the bond allocation of investors. The evidence shows the trade is getting quite crowded with unprecedented amounts of money flowing in. Additionally, issuers are putting out record amounts of bonds - another troubling sign.

The truth is we have next to no data on this asset class to evaluate this type of investment properly. But the mutual fund and ETF industry has found plenty of demand for this "product" and they are happy to churn it out for willing buyers. Caveat emptor.

Over at the investment banks and hedge funds, they need something to trade in the sovereign debt area (not all those traders were laid off) and some new area of sovereign debt to underwrite and distribute and collect fees. Investors have been burned by the product of past years: debt of the PIGS (Portugal Italy Greece and Spain) and the trading and underwriting has dried up in that area, to say the least. Hedge funds and proprietary trading desks no longer have Southern European debt to trade in a liquid market. So on to the next asset class, fuelled by low cost money from the Fed and the ECB.

On the investor side it's easy to figure out what is driving this money flow. Investors have been squeezed by what some have called the "financial repression" through the easy money policies of the ECB and Fed. Yields on what are considered the stronger sovereign debt such as Germany and the US have been brought down to such low levels that it is difficult to see where buy and hold investors will generate a real return. And these investors are certainly not willing to touch the sovereign debt of the weaker Europeans.

Where to go?

Next stop, it's on to emerging market sovereign debt - the new hot asset class. This is the case for individuals and also the case for institutional investors. The individual investors have little or no experience or knowledge of these bonds, other than the high yields they can easily look up.

Not only funds and ETFs specifically mandated to invest in this asset class are piling in. Pity the poor fund manager with a mandate to hold only global government debt - he has nowhere to go except emerging market sovereign debt.

The rationale for investing in this asset class by those selling and buying this product? These countries have better financials than the developed markets in terms of budget or trade deficits. Also, the absence of a loose monetary policy might lead to stronger currencies and less inflation down the line.

Besides, the sales pitch continues, emerging markets have performed well in the recent crisis-prone financial markets. True enough but other types of bonds have produced better or almost the same returns at lower risk. Below I chart Treasuries (NYSEARCA:IEF), emerging markets (NYSEARCA:EMB), corporate bonds (NYSEARCA:LQD) and high yield bonds (NYSEARCA:HYG). Total return is on top, volatility is underneath:

Seems like the product is flying off the shelves:

From the WSJ:

Emerging-market bond funds have been among investors' favorites since 2009. In the last three years, investors poured a net $29 billion into the funds, according to data compiled for the Journal by Morningstar Inc. In 2011 alone, investors bought a net $12.5 billion, up 380% from a net $2.6 billion two years earlier, despite a heavy selloff during the last four months of the year that was partly driven by a worsening of the European crisis.

The FT reports:

...the net asset value of dedicated emerging market bond funds tracked by EPFR Global, a data provider, has climbed from $34bn at the end of 2004 to more than $180bn today.

From the WSJ:

The result of these massive inflows: a nice lift in total return - but a sharp decline in yields:

The FT reports:

The overall blended yield of JPMorgan's EMBI Global Diversified index which is near an all-time low of 5.6 per cent. At the peak of the financial crisis in 2008 the gauge hit 12.3 per cent, but last year it touched a record low of 5.2 per cent.

Some investors share my skepticism. PIMCO, Legg Mason,and AllianceBernstein have all reduced their exposure to these markets according to the WSJ. Others raise the same concerns that were raised in my earlier article about the liquidity in this relatively young market should some of those inflows doubtless from individual yield chasers run for the exits at the same time.

"You always have to be concerned when this much money goes into a fairly small market," noted the manager from Alliance Bernstein quoted in the WSJ.

Another troubling sign: lots of "product" i.e newly issued bonds hitting the market. As I pointed out in my article on corporate bonds, when issuers and investment bankers are rushing to churn out new bonds, it might be a sign that the issuers are on the more correct side of the trade than the purchasers. Emerging market debt issuance hit a record level of $849 billion last year

One last factor - political risk. Russia is the second largest holding at 4.66% of PCY. Let's just say the Russian political situation is not exactly stable.

I'll pass on this asset class.

Source: The Emerging Market Bond Trade Is Getting Very Crowded

Additional disclosure: Mr. Weinman's clients own LQD and HYG