Segments of the EM debt market have been bright spots in fixed income this year. Will EMs outperform DMs in the months ahead—or are the risks too great? It may come down to country and credit selection.
The momentum that emerging markets (EM) debt experienced in the second quarter continued through most of the third—even as market-level performance lost some steam toward quarter-end as concerns grew around a second COVID wave and its impact on the global economy. Corporates, sovereigns and rates ended the quarter in positive territory, while currencies continued to lag. Looking at performance across the market, EM corporates led the way, returning 2.75%, followed by sovereign (2.32%) and local debt (0.61%).1
EM DEBT YEAR-TO-DATE PERFORMANCE
Source: J.P. Morgan. As of September 30, 2020.
Corporates: Much Will Depend on Pace of Demand Recovery
Since March, EM corporates have benefited from a wave of support from governments and banks in the form of moratoriums and forbearances, which continued through the third quarter. This support has helped insulate the asset class from some of the negative impacts of the pandemic—evidenced by EM corporates’ solid second quarter earnings season and a corporate default rate that, at 2.9%, remains well below initial forecasts of 4.5%.2 During much of the quarter, commodity prices also continued their recovery, providing support to cyclical sectors like oil & gas, metals & mining and industrials.
Toward the end of the quarter, however, concerns resurfaced around a potential second wave of COVID, and the impact that could have on demand. At the same time, questions emerged around whether some of the forbearance and stimulus measures that have been supporting the market up until this point may begin to taper off in the months ahead. In our view, this is one of the biggest risks facing EM corporates—that demand (including commodity demand from China) will falter amid another wave of COVID, preventing companies from generating enough revenue and EBITDA to service their debt in the absence of further support programs.
To that end, while select opportunities continue to emerge, the key is identifying those companies with business models that are resilient enough to withstand a slowdown in demand. Companies in defensive sectors like consumer, utilities and telecom, media & technology (TMT), for instance, look relatively well-positioned and indeed started to rally toward quarter-end. Further, some LATAM metals & mining companies with a cost of production in the first quartile of the global cost curve may likely remain resilient in the challenging market. Conversely, due to current forbearance measures, the delayed recognition of non-performing loans in financials could pose some challenges for the sector in the coming years.
At a high level, we continue to believe the high yield segment of the market looks attractive. Earlier this year, the spread differential between the high yield and investment grade segments widened materially, reaching over 700 basis points (bps). While this has narrowed somewhat in recent months, at roughly 400 bps3 it remains wide relative to the pre-crisis differential—suggesting there is further room for spread compression in selective parts of the high yield segment. Within high yield, we also continue to see value opportunities in short-dated bonds, which can provide an opportunity to pick up incremental yield and diversification, with less volatility.
EM SOVEREIGN AND CORPORATE SPREADS (INVESTMENT GRADE VS. HIGH YIELD)
Source: J.P. Morgan. As of September 30, 2020.
Sovereigns: Can (and Will) Countries Pay?
It was a similar story on the sovereign side, where the market maintained its recovery through most of the third quarter before giving way to volatility and minor spread widening at quarter-end. Of note, while the market has recovered much of its spread widening since the height of the volatility, there remains a disconnect with the real economies of emerging markets, which may take years to get back to full capacity. Against this backdrop, one of the key questions going forward is which countries can, and will, satisfy their debt obligations. In terms of ability to pay, there are a number of countries that appear to be in fairly good shape—Mexico, for instance, looks quite strong from a financial perspective given its robust foreign reserves. Russia, Thailand and Peru also appear able to pay, as do emerging European countries like Hungary, the Czech Republic and Poland.
Analyzing whether a country is willing to pay its debt is more complicated, due in part to the involvement of international financial institutions like the World Bank and International Monetary Fund. In recent months, there have been indications that these institutions may encourage EM countries with high debt-to-GDP ratios to restructure their debt. In our view, analyzing a country’s solvency based on this GDP ratio can be misleading, as some countries are able to borrow at very low rates and therefore accommodate much higher debt-to-GDP ratios than others. Compounding this, many EM countries—especially in the high yield space—will need further financial assistance from these institutions in the years ahead, which could result in some countries experiencing pressure to restructure as a condition of receiving financing.
Given these considerations, it’s almost impossible to make broad, sweeping conclusions about the attractiveness of the sovereign landscape. But on balance, we continue to see particular value in countries that are investment grade-rated, including Columbia, Romania, Russia and Brazil—a country that we rate internally as investment grade. On the high yield side, we are more discriminating, but see potential opportunities in countries like Ukraine, Azerbaijan and Central and Eastern Europe economies like Croatia, Albania and Macedonia.
However, country and credit selection are crucial in this environment, given that next year is likely to be a challenging one, and we are focused on avoiding countries where financing measures are deteriorating and that therefore may experience credit rating downgrades going forward.
From COVID-19 to trade tensions to the U.S. election—there are, and will continue to be, a plethora of risks for EM sovereigns and corporates to navigate economically, politically and from a market perspective. But there are also opportunities, which can be particularly compelling during times of stress. The key going forward will be picking the right credits and securities—especially when it comes to avoiding the ‘bad apples’ and identifying resilient countries and corporates that can withstand the current challenges in the market.
1. J.P. Morgan. As of September 30, 2020.
2. J.P. Morgan. As of September 30, 2020.
3. J.P. Morgan. As of September 30, 2020.