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EM Local Debt’s Time to Shine?

2020 January - 3 min read

Emerging markets (EM) local currency denominated debt may be poised to outperform.

EMD performance was strong across the board in 2019, and the fourth quarter was no exception. It’s perhaps no surprise that sovereign hard-currency denominated bonds were the star performers throughout much of the year—typically viewed as somewhat lower-risk than their local-currency denominated counterparts, the asset class benefited from higher duration in a year when rates largely trended downward. 

Toward year-end, this trend began to reverse. And while attractive opportunities remain across the sovereign hard-currency universe—particularly in countries like Brazil, where credit risk appears to be overpriced—attractive value has also emerged elsewhere.

In the fourth quarter, EM local currency bonds (5.2%) were the standout, outperforming both sovereign debt (1.81%) and corporate debt (2.2%).1 There are a few factors that may have contributed to this. Following the global financial crisis, the economy went through a massive deleveraging that resulted in an exodus out of riskier assets, EMs chief among them. Because of these outflows, EMs have been running smaller account deficits over time. As a result, the financing needs of EMs have come down over the last decade—meaning their balance sheets are in much better shape today. The headwinds faced by EMs have also battered their currencies and, based on measures that consider currencies’ real effective exchange rates relative to their terms of trade, EM currencies are now trading close to their cheapest levels in a decade. 

EM Currencies Trade Near Cheapest Levels in Last Decade (Real Effective Exchange Rate/Terms of Trade) 

Source: Haver Analytics. As of September 30, 2019.

The alignment of these factors suggests that the stage may now be set for the decade-old aversion to risk to begin to reverse course in 2020—paving the way for EM currencies to outperform, and potentially driving strength in EM local debt. 

Another area that remains attractive is EM corporate debt, which has one of the highest Sharpe ratios of any major asset class over the last decade. Fundamentals remain stable, with many companies exhibiting positive revenue and EBITDA growth in recent years. Balance sheets have remained healthy and default rates have stayed low.

Drilling down, short-duration high yield debt looks particularly attractive, and its lower interest rate sensitivity could prove valuable if global economic conditions improve this year. Given the various idiosyncratic risk flare-ups in several high yield rated countries over the last few years, corporate spreads have in many cases widened, despite relatively strong fundamentals. The spread differential between EM investment grade corporates and EM high yield corporates also remains at elevated levels compared to the averages of recent years, suggesting that relative value is still on offer in the high yield segment of this universe.

High Yield Continues to Offer Good Relative Value Versus Investment Grade in EMs

Source: Bloomberg. As of December 31, 2019.

Despite these market opportunities, it’s important to remain mindful of the risks that come alongside them. As we discussed in our 2020 Outlook, we believe the single largest risk facing investors in the year ahead is the potential for a material slowdown—or even a recession—in China. While we view this as an extremely unlikely scenario, if it were to occur, it could have serious repercussions on the broader global economy. 

The discord in the Middle East is another concern, and any missteps could have very serious ramifications—particularly considering that the region represents about 30% of the world’s energy supply, 20% of global trade passages and 4% of global GDP. This, combined with a number of ESG concerns, has led us to believe that the geopolitical risk in the region is underpriced. 

Despite the recent U.S./China trade agreement, we expect to see mixed headlines throughout 2020, and it seems with each passing day another emerging market suffers from political unrest or popular uprising. From Chile to Colombia to Ecuador to Hong Kong, there is no shortage of hot spots. A number of idiosyncratic risks have emerged as well, with Venezuela, Lebanon and Argentina chief among them—in each of these countries, bond prices dropped precipitously as tensions escalated. In fact, during the fourth quarter, nine countries were in default or distress scenarios—the most in a decade.  

All of these factors undoubtedly represent risks, and these risks must be taken into account in the form of country and credit analysis. But they also represent opportunity.

When corporate debt issuers are unduly punished for the country in which they are domiciled, or when negative headlines result in an overreaction in a country’s currency, active managers, and therefore their investors, can possibly benefit. Likewise, when it comes to EM sovereign debt, country selection matters—and it matters a lot. And while there are certainly a number of bad apples, there are also bright spots. 

The bottom line is that value opportunities exist today across all three of these markets, and will continue to appear going forward. But it’s not a time to ‘buy the market.’ Rather, it will take careful analysis of macro, country and company-specific risks, and the willingness and ability to move quickly, and with intention, when opportunity arises.

1. Source: J.P. Morgan. As of December 31, 2019.

The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service.  The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research.

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In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate.

Unless otherwise mentioned, the views contained in this document are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice.  Parts of this document may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any forecasts in this document are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Any investment results, portfolio compositions and/or examples set forth in this document are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments.  The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this document.  No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments.

Investment involves risks. Past performance is not a guide to future performance. Investors should not only base on this document alone to make investment decision. 

This document is issued by Baring Asset Management (Asia) Limited.  It has not been reviewed by the Securities and Futures Commission of Hong Kong.

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