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NEW YORK, Aug 24 (IFR) - Latin American bonds may be overvalued but funds dedicated to the asset class, overwhelmed by flows from investors gripped by a global hunt for yield, may have little choice but to continue buying them.
Since late July, a whopping US$6bn has flooded emerging market bond funds as investors took an overweight position in EM debt for the first time since the so-called taper tantrum in May 2013, according to the Institute of International Finance.
Though this level of involvement in the region's debt was initially welcomed after a tough couple of years, some market players said it has now pushed valuations to levels that made little sense based on underlying fundamentals.
"We are getting to levels where spreads don't compensate for risk," said Jorge Piedrahita, CEO of broker Torino Capital LLC.
"Argentina 2019s are almost at 3%. The country was in default just six months ago. There is a lot of complacency in the market place."
Reference spreads on the CEMBI - JP Morgan's EM corporate index - recently hit a 13-month low at 308bp, marking a year to date return of 12.56%. That return is an even larger 18.25% for the Latin American composite of the index.
"You have to really go back to early 2013 to see a sustained period of spreads at these levels," said Jason Trujillo, a senior credit analyst at Invesco.
"But at that time corporates had a stronger fundamental backdrop, now you have a more challenging picture. This leaves me a bit cautious."
The rush towards EM began steadily earlier this year as commodity prices stabilized, while leadership changes in both Brazil and Argentina have made Latin America debt a particularly popular place to park money.
Adding to that rush was a renewed bid from accounts looking to bolster returns amid accommodative monetary policies across the developed world.
Not only have big US asset managers like BlackRock and PIMCO been bullish on EM debt, but European accounts - which saw 10-year German bund yields turn negative for the first time ever in June - have taken a particular shine to the asset class.
"If you see German insurance companies that have never put money to work in LatAm before asking for offers in higher quality names, you have to pay attention," a New York based trader said.
Of the US$12.8bn flowing into external EM bonds since Britain voted to leave the European Union on June 23, US$8.2bn has come from European domiciled funds, according to Bank of America Merrill Lynch.
Such demand is hard to ignore in a market where supply has been limited.
This is particularly true in Latin America, where the abundance of liability management trades and refinancings has meant limited net new supply despite an uptick in new issuance volumes.
"You have to take into account not just the rally but the monetary conditions that have contracted spreads," said Graham Stock, head of EM sovereign research at BlueBay Asset Management.
"If you don't expect a major reversal in that element, it might be premature to call an end to the rally. It is not just EM performing well but other asset classes are too."
Indeed, US high-yield markets have enjoyed their own rally, leaving yields considerably tighter than their EM corporate counterparts.
For instance, the average Double B yield in the US junk market is around 4.823%, according to Bank of America Merrill Lynch. The yield to maturity on the Latin American component of JP Morgan's CEMBI, where average credit ratings are BB+/Ba2, is 6.133%.
Some investors however insisted valuations may still not have reached a peak.
Sean Newman, a senior portfolio manager at Invesco, said that sovereign spreads had room to narrow even after JP Morgan's EMBI Global Diversified hit a close to 15-month low of 330bp last Friday.
"Commodities have by and large stabilized, several countries have embraced reforms, and central banks policy both within EM and the developed markets are supportive," Newman said.
"I am looking at a 314bp spread (on the EMBIG) as a critical level. That is my sign post right now."
There are others who simply don't want to lose out even if they realise it's probably time to stop buying at current levels.
"Right now everyone recognizes this is unsustainable but no one wants to be the first to sell because that means underperformance and that is very uncomfortable," said a portfolio manager.
Another said investors continued to buy because "they would rather make money than be right." (Reporting By Paul Kilby; Editing by Shankar Ramakrishnan)