It's hard to argue that Indonesia is a better credit than Spain

You don’t have to be Einstein to conclude that as bad as 2010 has been for peripheral European countries, it has been a defining and positive year for emerging market debt. According to EPFR Global, EM bond funds reported net inflows of $40 billion in the first nine months of the year; more than four times as much as the previous full-year record in 2005. If the official sizes of the order books for any new issues of EM debt – sovereign and corporate – are to be believed, the allocation shift seems set to continue.

In many ways, it is not difficult to see the lure of the emerging markets. While many advanced countries continue to suffer the lingering effects of the financial crisis and ensuing global meltdown, many emerging economies have shown a hitherto unproven resilience in the past couple of years. As well as a considerably better growth outlook, the stronger emerging countries are not burdened with debt mountains and crippling deficits; problems the US and Europe are struggling to deal with now, and which had been the downfall of many EM economies in the past.

If current bond yields are a true representation, investors are determining that a dramatic shift in the balance of economic power is taking place; one that is reflected in the inflows, but certainly not in sovereign debt ratings. Why else would 10-year double-B minus rated Indonesian government bonds, which yielded 5.87% in May this year, be trading at 3.75% on October 25; or similar dated debt from the Philippines (also rated double-B minus) offer yields a whisker under 4%? To put those yields into perspective, 10-year Spanish government bonds currently trade at 4.06%.

Undoubtedly, the Spanish government has some serious problems to address, including weakness in the real estate and banking sectors, and an unemployment rate that reached 20.5% in August. It is also true that estimates of default risk by the major rating agencies do not always align with those of investors. All that being said, the ratings difference between Spain and Indonesia/the Philippines is 10 notches.

Either the agencies’ methodologies are hopelessly inaccurate and Spain is really a higher-risk proposition than the Philippines or Indonesia, or there could be a case to suggest that a chunk of the money currently pouring into EM debt is being allocated indiscriminately. Potential is one thing, but the dramatic compression of EM bond yields could yet be a case of too much, too soon.