Emerging market credit quality reached new heights in the third quarter of 2005 as spreads plummeted amid record inflows into this asset class, according to a report released by Standard & Poor’s Ratings Services. Total returns outstripped other asset classes by a substantial margin.

Upgrades outpaced downgrades in emerging markets by a growing margin; the downgrade ratio of 2% was the lowest since the second quarter of 1996, when the overall size of the rated universe was sizably smaller. Third quarter upgrades were driven in large part by the banking sector in the Asia Pacific region.

“The near-term credit quality outlook is still upbeat, with more emerging market entities listed with a positive bias than a negative one, in contrast to the trend in developed economies,” observes Diane Vazza, head of Standard & Poor’s global fixed income research group.

The drop in negative bias has been compensated for by an increase in entities with a stable outlook, whereas the positive bias appears to have stabilised.

As of September 30, 2005, only 6% of rated issuers in the emerging markets had either a negative outlook or ratings on CreditWatch with negative implications, lower than the 10% recorded a year ago.

The report, titled “Emerging Market Credit Quality Reaches New Heights ‘, states that all three major regions experienced a reduction in negative bias relative to a year ago, but positive bias showed the greatest pickup in Latin America, while it shrunk in Asia Pacific and stayed the same in the Eastern Europe/Middle East/Africa region.

Varying credit-quality prospects by region imply that investors will continue to differentiate selectively.

By sector, emerging market banks and sovereigns appeared best positioned for potential upgrades at the end of the third quarter, with 15% and 13%, respectively, of rated entities within each sector listed with a positive bias. The utilities sector appeared most vulnerable to potential downgrades.

Option-adjusted spreads on emerging market corporates (as measured by Merrill Lynch) remain compressed at historical lows, and, in perhaps a sign of maturation in the segment, were lower than their counterparts in US high yield by a growing margin since April. Emerging market spreads declined to a mere 286bp as of October 19 from 319bp at the end of June and 354bp at the end of 2004.

Total return for emerging market sovereigns recorded the biggest advance of all fixed-income asset classes in the third quarter, according to Merrill Lynch. Third quarter returns were 3.86% and year to date gains were 9.75%.

Despite the current optimism, concerns are mounting. Global financing conditions are expected to be more challenging in the coming months, as interest-rate hikes in countries like the U.S. temper the appeal for higher-yielding emerging market bonds. The steep surge in oil prices has added a heavy burden to oil importing nations, though it has ushered in windfall gains among exporters. In addition, the recent leveling of commodity prices raises caution about emerging-market prospects, since many countries rely heavily on commodity export earnings.