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Emerging market bonds
Preference: overweight

UBS View
EMBI Global / CEMBI spread (27 June): 388bps / 430bps (last month: 410bps / 440bps)
EMBI Global / CEMBI spread target (6-month): 340bps / 350bps
• Emerging market (EM) bond spreads are currently higher than implied by fundamentals, and we think they offer attractive returns even against a more challenging global backdrop.
• The probability remains significant, though, that negative headlines out of the Eurozone or a weakening global growth outlook will put short-term pressure on EM bond prices. However, given EM sovereigns' better average fundamentals, and EM corporates' solid profit growth outlook and low leverage ratios, we think that periods of price weakness should offer attractive entry points.
• Although we revised our spread targets (to 340bps from 300bps for sovereigns, and to 350bps from 310bps for corporates), we continue to expect spreads to trend gradually lower over the next six months, more than offsetting the moderate rise in US Treasury yields we expect in the quarters ahead.

Positive scenario
EMBI Global / CEMBI spread target (6-month): 290bps / 290bps
• Yield stability in Europe's core markets and higher-than-expected growth in the US would provide a favorable backdrop for EM fixed income spreads. In such an environment, issuers of lower credit quality would likely fare better. Average spreads could tighten to below 300bps in such an environment.

Negative scenario
EMBI Global / CEMBI spread target (6-month): 525bps / 700bps
• An environment of escalating risk aversion in Europe, deteriorating EM funding markets, weakening global growth prospects, and lower commodity prices could impact EM credit negatively. Liquidity in emerging market bonds could dry up and spreads could spike.
Note: Scenarios refer to global economic scenarios (see slide 7)

Recommendations
Tactical (6 months)
• EM corporate bonds are particularly attractive due to favorable valuation, solid fundamentals, and their relatively short duration. We advise clients to focus on investment grade bonds in the current environment. We continue to like selected sovereign bonds.
• Please refer to our EM bond list for specific guidance.

Strategic (1 to 2 years)
• EM bonds are attractive for longer-term investors looking for higher yields.
• Local markets in Asia offer interesting opportunities for longer-term investors because of a supportive currency outlook.

Room for tightening
Spreads of EM bonds over US Treasuries (in bps)
[Chart depicting spreads from Jun-09 to Dec-11/12]
Source: JP Morgan, UBS CIO, as of 27 June 2012
Note: Past performance is not an indication of future returns.

What we're watching
Core market yields

Why it matters
The direction of US Treasury and German Bund yields are important for EM fixed income spreads, especially for USD- and EUR-denominated bonds.
Key dates: 1 August, US ISM & FOMC rate decision

Capital flows
The European debt crisis may lead to further periods of outflows and weaker prices, which could offer attractive entry levels for investors.

Monetary policy cycles
Monetary policy easing remains a key topic for local currency bonds. We look for central bank policy announcements in key markets such as Brazil, Indonesia, Malaysia, Mexico, Poland, South Africa, and Turkey. Key policy rate announcement dates: 29 June, Colombia; 4 July, Poland; 5 July, Malaysia; 11 July, Brazil; 12 July, Indonesia; 19 July, Turkey

UBS
28
For further information please contact CIO's asset class specialist Michael Bolliger, michael.bolliger@ubs.com and Kilian Reber, kilian.reber@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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