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But could the downgrades caused by bearish analysts create opportunity for investors? Lower credit ratings and the sell-off in March could provide investors with more attractive entry points. Yet risks remain and default risk varies by country, with some nations managing the Covid crisis better than others. “The sover- eigns most exposed are those with generally weak credit funda- mentals, such as high debt and weak policy credibility; and those reliant on commodity exports or tourism, or with large external financing requirements, foreign-currency debt, hot-money inflows and low reserve buffers,” Fitch warned in a press release published in April. The effects of Covid also vary between hard- and soft-currency debt. While issuers of hard-currency denominated debt should initially benefit from a weaker dollar, local-currency issuers face a double whammy of currency volatility and weaker growth rates. So, emerging market bond issuers and investors might find them- selves walking a tightrope in the coming months. On the one hand, many countries are keen to increase borrowing to raise the capital need to fund the fight against Covid. Indeed, a conservative IMF estimate in March put the emerging market financing need- ed to tackle the crisis at some $2.5trn (£1.9trn). On the other hand, investors might see this as an opportunity to capitalise on the higher returns offered by bonds with a negatively revised credit rating. But the line between financing the response to Covid and funding an unsustainable debt burden may in some cases be very fine.
Happy days are here again Yet in November news of a vaccine for Covid-19 created optimism that some form of normality could return in early 2021. Even before this breakthrough was announced, some analysts were up- beat. In September, S&P forecast that the average emerging mar- ket economy, excluding China, would contract by 6.4% this year, but recover to grow by 6.2% in 2021. Not all economies are expected to report a decline this year. The rating agency is expecting Brazil, China, Poland, Russia and Tur- key to continue growing in 2020. So, are the problems as bad as feared during the peak of the crisis between March and May? It appears that opinions were already thawing before the vaccine announcement as international investors were lending to devel- oping borrowers again. In September, emerging market fortunes turned as $12.9bn (£9.9bn) of debt flowed into those economies, despite equity markets reporting more than $10bn (£7.7bn) in outflows, according to the Institute of International Finance (IIF). But analysts were cautious that the main challenges are yet to come.
“Our data shows that a big “risk-off” is brewing in EM,” warned IIF economist Jonathan Fortun when speaking to portfolio insti- tutional early in October. “We are tracking high frequency out- flows from EM in the final weeks of September almost as big as in
the 2013 taper tantrum or during 2015’s renminbi devaluation fears,” he added. Yet debt flows in October were largely flat at $11.7bn (£8.9bn), which was mostly invested in Asia. This compared to $6.3bn (£4.8bn) of flows into equities, according to the IIF. The return of such bullishness could have been driven by improv- ing entry points following the sell-off in the Spring. Lower US interest rates could have been another attraction. In the three months to July, dollar-denominated debt issued in emerging mar- kets leapt 14% year-on-year, as corporates and governments took advantage of the Fed cutting rates to near zero. This presents another question that investors need to answer, namely, if interest rates rise on the back of the vaccine launch, could borrowers fund higher re-payments? Is this another crisis brewing as govern- ments and corporate struggling with lower growth and higher repayments?
Still bullish Daniel Wood and Luis Olguin, portfolio managers at investment bank William Blair, are optimistic about the asset class’ prospects. Speaking to portfolio institutional in May they said changes in spreads make for a buying opportunity and stress attractive valu- ations, positive flows into emerging market debt and global liquidity conditions will continue to drive asset prices. Such bullishness is shared by Uday Patnaik, head of emerging market debt at Legal & General Investment Management, who told portfolio institutional in May that emerging market paper will grow in popularity with pension schemes. Perhaps it is because market reactions to previous pandemics have been time-limited that fund managers retain an upbeat view of emerging market debt’s fortunes. Patnaik agreed that there was a problem with developing nation debt yields but believed that the entry point is enticing. He argued that notwithstanding the Coronavirus crisis, the yield- parched developed market conditions which made debt from issuers in the developing world an attractive proposition for pen- sion schemes remain in place and were unlikely to change any time soon. “You have investment-grade European bonds and investment- grade US bonds, but the problem is that developed market bonds are virtually at zero,” Patnaik said. “If you go onto the 10-year part of the curve it’s negative or close enough to zero. Could you imagine Germany with rates at 5% like the good old days? No. There’s too much debt. It is hard to imagine meaningful, sus- tained higher yields in the developed world.” There can be no way of knowing how long or how badly the Coro- navirus crisis will last, or if the vaccine announced in November will bring some form of normality back to the world in the com- ing months. But whatever happens, the pension scheme and emerging market debt story still has some way to run.
November 2020 portfolio institutional roundtable: Emerging market debt 21
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