Emerging bond markets are increasingly moving into the focus of investors. But not all of them will benefit equally from the recovery after the Coronavirus crisis. A differentiated analysis is indispensable.
By Nick Eisinger, fund manager for Emerging Markets Fixed Income at Vanguard
Emerging markets seem to be inundated with too much positive news. This sounds like an odd complaint for a risky asset class. After all, emerging markets should in principle respond positively to factors such as a stronger global economy, the gradual opening up to tourism and the firming of commodity prices.
The problem, however, lies in the starting position. At the beginning of the year, emerging markets were an asset class that offered decent returns against a backdrop of low global interest rates and where risk premiums were expected to fall as the global macroeconomic picture improved. This largely came true in January and February: spreads on emerging market investment grade (IG) and high yield (HY) sovereign bonds narrowed by about 10 and 30 basis points, respectively, by the end of February.
The background to this was the approaching end of the lockdown and the associated return to an economic growth path. This development has put further pressure on US government bonds. Although the US Federal Reserve and the ECB reaffirm their strategy of maintaining the low interest rate policy and general support measures for the foreseeable future. But the market is increasingly doubtful about this and is struggling to understand how policy (fiscal and monetary) can remain so loose on the eve of the lockdown exit and the associated economic recovery.
Breakeven inflation rates have anticipated this move for some time, but more recently we can observe a shift in nominal interest rates and – in the face of virtually unchanged actual inflation rates – a rise in real interest rates.
The key is to be aware of the impact of such a rise in US Treasury yields on emerging market fixed income assets. This is especially true for some of the higher quality emerging markets. In this sector, spreads are no longer sufficient to compensate for the losses associated with a sell-off in US Treasuries. Riskier emerging markets with higher yields are currently in a better position to overcome these challenges.
Thus, the aforementioned spread tightening in HY was sufficient to offset much of the negative impact from the widening of yields on Treasuries and, to a lesser extent, German Bunds and other G7 risk-free rates. IG government bonds, on the other hand, could not escape the pull to the same extent.
These current developments need to be taken into account when assessing the medium-term potential of emerging market bonds as a whole as well as individual sub-segments. Like any asset class, they will be significantly affected by the Corona pandemic and related containment measures. Overall, global vaccination programmes are having a positive impact on human health and emerging market growth. However, individual country fundamentals will continue to diverge depending on how successful governments are in implementing their support and vaccination programmes – and how much of a burden they place on government budgets.
Fundamentally, the fight against the pandemic has put a strain on public budgets in all parts of the world. Spending on medical care and stimulus programmes has increased, while tax revenues have declined with the economic slump. Although the public debt of the emerging countries already reached its highest level since 2002 at the beginning of 2020, the low interest rates make this debt burden appear sustainable overall.
It should be noted, however, that the credit quality of individual emerging markets varies greatly – with corresponding consequences for the financing of the crisis measures and the national budgets. This in turn has an impact on the outlook for the respective bonds. An analysis according to risk segments or credit ratings provides some insight.
Solvent emerging markets remain solid
Among the solvent emerging markets, Chile and Poland stood out with exceptionally large stimulus packages. In both countries, these included tax cuts as well as direct investments in their health care and social security programmes. According to the IMF Fiscal Monitor of October, these stimulus packages amounted to six to eight percent of economic output. This put both countries comparatively close behind the large economies, which spent an average of nine percent of their gross domestic product, while the emerging economies as a whole only came to three percent.
Chile and Poland were not only able to borrow abroad at historically low interest rates, but also on their own highly developed bond markets. This is because their central banks have gained a lot of credibility in the markets through years of successful inflation management. They also belong to the group of solid countries where central banks have been able to launch government bond purchase programmes.
These countries will, on average, take on more debt to overcome the Corona crisis, but they will also recover faster than less solvent countries, as they are also likely to suffer fewer deep recession scars. They will also be able to continue to support their economies thanks to high financing flexibility and good market access. The debt of these countries will rise, but their debt sustainability should not be at risk.
However, even within the group of solvent emerging markets, investors need to keep an eye on debt, as debt ratios could exceed certain rating thresholds. Malaysia and India, for example, are at risk of downgrades due to rising debt ratios. Careful differentiation of the more solvent emerging markets according to their credit profile therefore remains indispensable in this segment as well.
A dichotomy in emerging market middle quality
The middle quality segment has a wide range of very different credit profiles. On the one hand, the mid-range includes larger countries with higher debt ratios but functioning capital markets through which governments can finance themselves. South Africa and Brazil, for example, have borrowed large sums domestically. To keep borrowing costs as low as possible, many of the bonds have only short maturities. By financing domestically, the risk premiums have not increased too drastically, but the refinancing risks on the domestic bond markets are rising. In the medium term, these countries will have to seek debt sustainability. They can still borrow abroad; however, risk premiums will increasingly diverge – depending on the market’s assessment of the plans for medium-term consolidation and the ability and willingness to implement these plans.
Other countries in the spectrum, while not extremely indebted, have few reserves of their own or efficient bond markets, limiting their flexibility in budget financing. These include countries such as Paraguay, Jordan and Mongolia, which have so far financed themselves through external debt and subsidised loans from multilateral institutions such as the International Monetary Fund and the World Bank. These countries also receive support from the USA and other developed countries.
Poorer countries will need additional aid
Particularly affected by the pandemic were countries with weak credit ratings and crisis countries that had already found it difficult to finance themselves. Countries like Bahrain and El Salvador could only borrow abroad at high interest rates.
Most of these countries are heavily dependent on subsidised multilateral loans and bilateral debt relief such as the G20’s Debt Service Suspension Initiative. Others, including Ecuador, Argentina and Lebanon, have had to restructure their market-raised debt. Fiscal problems existed in many cases before the pandemic, but were further exacerbated by the crisis.
Overall, the sovereign debt of the countries with weak credit ratings shows considerable differences. An important differentiator for emerging market debt funds will therefore be the ability of their fund managers to correctly predict the development of the public budgets of these countries. Governments face a difficult balancing act: on the one hand, they need to consolidate their budgets; on the other, they continue to rely on multilateral financing and bilateral debt relief – especially from China, in many cases a major creditor. Among the countries on the threshold of over-indebtedness and facing difficult choices is Sri Lanka.
There will be more defaults and restructurings in this group in the coming years. For active emerging debt managers with a high level of fundamental analysis competence, however, this will certainly result in strategic opportunities.
At present, however, countries from the creditworthiness midfield are often to be preferred. In this segment, too, a careful and differentiated analysis of fundamental data and the corresponding selection of securities are gaining in importance. In many cases, however, they should benefit from a recovery of the global economy. At the same time, they offer greater protection against interest rates in the USA, which may continue to rise, than countries in the upper end of the quality spectrum can offer. In view of the historically low risk premiums, caution is advisable in this segment – an assessment that has already been impressively underpinned by developments at the beginning of the year.