Those who see emerging market debt as a safe haven should think again, according to Mike Riddell, a fund manager at M&G Investments in London.
In a research note on Tuesday, Riddell said he became concerned a couple of months ago when the "implied risk premium on emerging market debt suggested that the market was treating (emerging market) debt as a safe haven."
Bluntly, Riddell warned the "market was therefore smoking crack."
"Emerging market debt has shot the lights out for the best part of a decade, as investors have lapped up the strong growth rates, improving debt dynamics, stronger demographics and (particularly of late) much higher yields versus developed markets," said Riddell.
With performance strong and volatility low by historical standards, Riddell said a whole wave of investors have been tempted into local currency emerging market debt.
"It’s important to keep an open mind to the risks facing emerging markets, which very rarely get much coverage," said Riddell.
"Right now, the strengthening U.S. dollar is starting to cause a lot of problems, not so much because external debt is excessive in emerging markets (Eastern Europe is an exception), but more because one of the most crowded trades in the world is to be long emerging market (foreign exchange) and shortthe U.S. dollar."
With a similar trade being seen between the Japanese yen and the Brazilian real, as Japanese investors snap up yield in the Latin American power house of Brazil , Riddel warns unwinding of these trades when they turn could cause huge volatility.
"The most likely cause of a stronger dollar or yen is probably a worsening of the euro zone debt crisis, which is something we expect," said Riddell.
"Up until last week, emerging market local currency debt had been remarkably bullet proof in the face of global risk aversion, but this is suddenly starting to change with local currency government bonds and emerging market currencies having sold off sharply in the last week.
"It looks like the end investors in emerging market local currency debt are starting to liquidate their holdings, a suspicion strengthened by the Indonesian debt management office yesterday saying that foreign investors’ holdings of Indonesian government bonds fell by 5.6 percent in just one week.
"The damage this has done can be seen by Indonesian 10-year government bond yields having soared from 6.5 percent on September 9th to 7.4 percent today, while the Indonesian rupiah has fallen 5.3 percent against the U.S. dollar over that time period," said Riddell.
This is where things start getting scary, according to Riddell.
"There are a handful of enormous global bond investors with a very heavy exposure to local currency emerging market debt, with some owning over 50 percent of individual emerging sovereign bond issues," he said. "A reversal of the huge capital inflows into emerging market debt would result in a total lack of liquidity and significantly higher borrowing costs for emerging market countries,"
Riddel said he sees the chance of a rapid selloff becoming a systemic event for a number of emerging markets.