Feature – EM debt
If we do have a yield sell-off, all these long-duration bonds are gonna get killed. Stuart Trow, EBRD
But there are also good reasons why emerging markets might be better positioned to face the surge in inflows this time. While total debt levels are higher, borrowing costs have reduced dramatically as many emerging market governments locked in favourable borrowing rates by issuing bonds with a longer maturity. Yield spreads for some major emerging market econ- omies, including China, South Korea, South Africa, Russia and Indonesia, have fallen by around 120bsp in the past year, according to IIF and Bloomberg, making the debt burden rela- tively more affordable. The nature of the debt issued has also changed, with soft cur- rency borrowings taking on a much more prominent role. Across Asian markets, more than half of all government debt is issued in local currency. India, for example, has issued more than 85% of its sovereign debt in local currency, followed by Hong Kong (71%) and China (64%). The prevalence of soft cur- rency government debt is somewhat lower for most Latin American and Middle Eastern countries. Many emerging mar- ket economies also mainly borrowed domestically. This has put them in a better place to introduce their own quantitative eas- ing measures to ensure liquidity in debt markets, making the traditional textbook style external default scenario a lot less likely. India, for example, presented its budget in early Febru- ary, which includes a very loose fiscal policy in response to the Covid crisis, despite having already high debt burdens and has been faced with a positive market response.
Pitfalls Nevertheless, investors holding emerging market debt could still face pitfalls. For Stuart Trow, credit strategist at the European Bank for Reconstruction and Development, the low yield environment is an opportunity and risk for emerging mar- kets. “Central bankers and policy makers are now acutely aware how high asset prices are,” he adds. “In normal times, it would be inconceivable that the S&P500 gains 16% while the US economy lost 10 million jobs. People cannot see asset bubbles
48 | portfolio institutional | February 2021 | issue 100
because they cannot see the wood from the trees.” Nevertheless, in relative terms compared to other fixed income assets, emerging market debt could still offer some value. Whilst many corporate issuers are still reluctant to re-enter capital markets due to the uncertain economic outlook, emerg- ing market governments had become “the only game in town” in terms of issuance, benefiting from a “halo effect” of artifi- cially inflated asset prices across global markets, Trow says. While the ability to lock in longer term commitments works well for emerging market governments, it could turn into a risk for investors. “Companies now have no issue with pre- funding, so a lot of deals are being accompanied by tender offers for bonds, typically for this year or the year after but I’ve seen some going as far out as 2027. With that, we have already cannibalised future issuance to quite a heavy degree. That makes the dash for yield even more acute,” Trow says. “If we do have a yield sell-off, all these long-duration bonds are gonna get killed,” he adds. “If you bought them on an outright yield basis, they are the ones that are going to swing really quickly and aggressively.” For Ian Scott, the risk of a change in the Federal Reserve is also not completely off the cards, although it might pan out some- what differently than eight years ago. The market has come a long way in the past few months, that probably means that investors should temper their enthusiasm for the asset class a little bit. We have the prospect of US real interest starting to rise a little bit, at least temporarily, he says. “With investors having committed quite a lot of capital recently to emerging markets and yields having come down quite a long way that change in the direction of real interest rates might lead to some sort of reconsideration by investors and the key dynamic here is how much real rates in the US might rise. This could feed through to a stronger performance for the dol- lar, and history tells us that this is a more difficult backdrop for emerging markets,” Scott says. With some investors raising cautions that sections of the emerging market debt market might be overheating, approach- ing the asset class selectively and with caution could pay off for most asset owners. Lasocki believes that investors might be more likely to find value in the more niche segments of the market, such as corporate debt from issuers with high yield or even distressed ratings.
Scott also stresses that investors should assess the merits of individual emerging market issuers on a case-by-case basis. Despite the delays of rolling out vaccines across emerging mar- kets, remains cautiously optimistic. “Access to vaccines for emerging markets has to be a concern. But when you look at the way markets have traded more gener- ally, investors now seem quite prepared to look past the pan- demic,” he says.
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