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A rally in emerging market debt assets has gained traction following a very difficult period starting from March, which we consider to be one of the worst months in the history of the asset class—on par with the global financial crisis.
The demand, supply and oil shocks that hit the global economy and capital markets were exacerbated in the case of emerging market debt by extreme outflows, which manifested in indiscriminate selling of exchange-traded funds (ETFs).
Macroeconomic factors have mostly driven the rally, along with the US Federal Reserve’s (Fed’s) extraordinary liquidity provision in March that really turned the tide. Some recovery in the price of oil to its present level around US$40 has also played a part in the rally.
We consider liquidity a factor intrinsic to the asset class that contributes to the inefficiency of the market, which thereby creates opportunity. While the general trend since the Fed’s liquidity injection has been a tightening of spreads, helped by a significant improvement in trading conditions, liquidity remains a major factor and its absence has certainly caused significant volatility for individual bonds.
A patient approach is often needed to source bonds at attractive prices. We also like to look for opportunities beyond standard benchmarks to debt instruments which have sufficient liquidity premium priced in.
An Asset Class Divided
Several factors have continued to provide liquidity to the emerging market debt market. The Fed’s decision to buy investment-grade US bonds has had a trickle-down effect, while the International Monetary Fund’s emergency financing has supported some specific countries and central banks. Within emerging markets themselves, governments and central banks are also providing significant counter-cyclical support. And, as we’ve previously mentioned, successive crises over many decades have encouraged better management of public debt stocks. This has resulted in improved credit quality as well as governance in emerging markets, creating resilience against further shocks.
Despite the general improvement in trading conditions, we have seen a bifurcation of the market, with stronger sovereigns and corporates rallying back towards pre-crisis tights, while other weaker names continue to reflect illiquidity and elevated default risk. Primary market activity has been skewed towards investment-grade issuers for sovereigns and corporates, however.
In the last week of June, we saw some strong issuance from B and BB sovereign issuers. We’d largely expect this trend to develop as the remainder of 2020 plays out against a backdrop of macro-driven factors such as government policies and continued improvement in the global economy.
For corporates, we saw a turning point in what would have been a vicious cycle into a more virtuous cycle. It’s worth recognizing that there have been significant forbearance measures—a temporary pause on repayments—and macroprudential loosening in the emerging economy, similar to what we’d seen in developed markets, which has allowed some confidence to eke back in.
Year-to-date, emerging market corporate bonds in aggregate have recovered around 60% of their increase in spread over US Treasuries, but have already broken even on a total return basis.1 We have seen a handful of emerging-market corporates default so far, and our expectation is that the default rate should likely trend upward to high single digits over the remainder of the year as those industries particularly exposed to the COVID-19 crisis, such as retail and transport, remain under pressure.
However, historically, emerging market corporates have been no more prone to defaults than their developed market counterparts, so we see no reason currently why this will not remain the case. It’s also worth remembering that high-yield bonds only account for around a third of the universe of emerging market corporate bonds, which is a much lower proportion than many people expect.2 This means that the default rate for the asset class as a whole will likely remain in the low single digit percentage, in our view.3
As spreads continue to tighten over the course of the year, there will undoubtedly be bumps. Companies themselves have been able to issue bonds in a similar manner to sovereigns—issuance has been US$237 billion year-to-date, only slightly behind 2019,4 though skewed heavily towards the investment-grade part of the market, and Asia. We see positive signs that many companies have been able to refinance, enhance their liquidity positions and draw down on credit lines. And in some cases, they have been able to garner support from government stimulus packages.
In the short term, some bonds in certain markets arguably have rallied too far, too fast. From a fundamental perspective, there is now the prospect of a range-bound period of consolidation until we see second-quarter gross domestic product figures. Questions remain over the valuations of all asset classes in what is an unprecedented period for markets. We largely expect more volatility, but perhaps less so than in the first quarter.
Over the longer term, interest rates in developed markets now look to remain low, so we expect emerging markets that offer an attractive spread will be in demand. At the same time, we think the asset class continues to offer diversification for many investors.
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What Are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
1. ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, June 2020. Past performance is not an indicator or a guarantee of future performance. Important data provider notices and terms available at www.franklintempletondatasources.com
2. ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, June 2020.
3. There is no assurance that any estimate, forecast or projection will be realized.
4. Source: JP Morgan, Bloomberg, Bondradar, June 2020.