Emerging markets debt: still in favour?
Back in August volatility in emerging markets (EM) bonds rose given continued trade tensions and as the growth profile for most EM economies seemed to show some cracks. In addition to this, country idiosyncratic risk emerged again. So is it time to turn one’s back on the EM asset class? In this article we provide a brief overview of some key recent developments in emerging markets and show why we believe that US dollar-denominated EM bonds are still worth considering.
The biggest focus for EM investors last month was on debt-laden Argentina. Argentinean international sovereign bonds, now rated CCC-, have lost over 30 cents on the US dollar since July and are trading at distressed levels of around 40 cents on the dollar. The loss also had a negative impact on spreads at the broader EM index level.
The price drop in the bonds followed a chain of political events. The first round of the presidential election put the populist Alberto Fernandez, backed by former president Cristina Fernandez de Kirchner, in front. The former government regularly clashed with the International Monetary Fund (IMF), which provides financial support in the form of a $56bn loan.
Rightly, market participants are concerned that this financial support could quickly cease. The government’s halting of domestic debt payments has increased tensions further with the IMF, which is deciding whether to disburse a planned $5.4bn tranche or to withhold any payments, which could deepen the crisis. Meanwhile, currency reserves, which are at already low levels of only $15bn, are melting rapidly.
Asian high yield (HY) issuers have been another area of concern for investors. Chinese property issuers (50% of the Asian HY market) in particular have been weaker, contributing to the recent spread widening in the EM market. Asian HY bonds widened by 120 basis points (bps) on average in August, while HY bonds in EEMEA (Eastern Europe, Middle East and Africa) only widened by 55bps in comparison.
Although higher leverage and concerns of an overheated property market are valid concerns, China has already taken steps to support lenders and developers by lowering bank funding requirements. Given ongoing trade tensions and deteriorating growth in China, we believe that bonds of Chinese high yield industrial issuers look most vulnerable to higher volatility. The Chinese manufacturing purchasing managers’ index was reported in August to be in contractionary territory for the fourth consecutive month.
Weaker growth prospects
In addition to Argentina and China, Brazil and India also face lower growth prospects. The Brazilian economy shrank 0.2% in the first quarter this year, from 0.1% growth in the previous quarter. Meanwhile, India reported its lowest GDP year-on-year growth rate in six years at 5%.
By contrast with Argentina, both Indian and Brazilian governments have already implemented measures to support their respective economies. While the pension reform should provide more financial flexibility in Brazil, India’s support to the financial sector in the form of capital injection, lower policy rates and consolidation in the banking sector, which should aid economic prospects for both countries.
EM inflows pick up
The spread widening which accompanied global EM outflows in August has quickly been followed by inflows again in September. The prospect of trade talks between China and the US in October combined with more attractive spread levels has led to renewed investors’ interest. Spreads of USD EM bonds are now trading at their 10-year average levels of roughly 322 bps (see chart).
Continued monetary accommodation by central banks globally and depressed yields in the developed markets will likely support demand for higher yielding EM debt in our view. However, the diverse nature of the EM bond segment means that selection will be key.
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