Emerging Market Debt: Babies In The Bathwater
This summer witnessed a complete capitulation towards emerging market (EM) investments – stocks, bonds and currencies. Investors have swung full circle from last decade, and have now turned pessimistic on long-term EM economic prospects. While it is too soon to return to most EM stock markets and currencies, there is one area that stands out as being attractively valued for global investors seeking higher yields with low risk – namely, EM dollar-denominated debt.
This summer’s global bond rout has seen significant increases in both government bond yields and wider spreads on high-yield (HY) corporate bonds and EM debt over Treasurys. However, the damage has been disproportionate in the latter: yields on EM dollar debt are now roughly equal to the yields on U.S. HY corporate bonds, a rare event. Keep in mind, EM dollar debt entails no currency risk for U.S. dollar-based investors.
Historically, most EM bonds have had a lower default risk than HY bonds. True, the late-1990s witnessed a spate of losses in the EM world, courtesy of the Asian currency crisis. However, most EM countries are in far better financial shape than 15 years ago. Nevertheless, there has been indiscriminate selling of EM bonds.
One key difference between EM and HY bond markets is that they attract slightly different types of investors. Ownership in HY bonds tends to be dominated by fixed-income investors looking for the best relative bond play. Such investors tend to maintain corporate positions in an improving economic backdrop (i.e. when the level of bond yields is rising and absoluteperformance may be poor). EM debt, conversely, has attracted a broader range of investors in recent years, including those more focused on seeking absolute returns. The latter unloaded all bond holdings as yields rebounded.
In sum, like the proverbial “babies in the bathwater”, EM dollar-denominated debt has been abandoned. This has created an attractive investment opportunity for fixed-income investors seeking higher yields, relatively lower risk and no EM currency exposure.
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Warren C. Smith, MRB – The Macro Research Board