Emerging market debt: All about the yield

The below is an extract from our Q3 Active Fixed Income Outlook.

The past: what just happened?

Persistent outflows, unexpected election outcomes in several countries, and volatility in US rates have all represented headwinds for emerging market (EM) debt. However, tighter spreads, except in Venezuela, and a recent rally in US Treasuries following the sell-off in April, contributed to positive total returns for the asset class across sovereigns and corporates this year. This rally in rates means that EM investment grade (IG) returns turned a corner in the second quarter and are flat for the year.

The high yield (HY) segment within EM has been the clear outperformer this year. The high yield sovereign index has seen gains of approximately 5.7%[1], while the high yield corporate index has risen by around 6.2%[2]. This outperformance is attributed to factors such as lower sensitivity to rates volatility compared to investment grade bonds, positive idiosyncratic developments in selected credits and stable macroeconomic fundamentals.

The present: idiosyncratic stories drive returns

Sovereign high yield spreads, excluding Venezuela, tightened by c.50 basis points (bps) between January and May[3]. Much of this outperformance has come from lower rated/distressed sovereign credits, where idiosyncratic developments are driving returns. These credits, including Pakistan, Egypt and Argentina, have benefited from strong support from multilateral agencies such as the IMF and bilateral donors, which has anchored reform agendas.

Defaulted names like Zambia, Ghana and Sri Lanka have been helped by progress made towards completing their debt restructurings. Indeed, Zambia was the first to complete its Eurobond restructuring. Ghana and Sri Lanka do not seem far behind. A successful exit this year will help bring HY spreads further down. Hence, despite the year-to-date spread rally, we believe there is still value in this segment – current levels (707bps) look cheap compared to pre-COVID levels (c480bps)[4] as well as versus US high yield.

In corporates, too, the high yield segment has shown robust performance. Default rates within EM corporate high yield have significantly decreased to approximately 1% year-to-date, from a peak of 14% in 2022. While default rates have remained elevated in recent years, this has been primarily concentrated in Chinese real estate, Russia and Ukraine (c.80% - 90% contribution to total defaults in 2022 and 2023). Notably, China has taken nascent steps to support its property sector this year, which could reduce default rates. Meanwhile, on the technical side, the expected negative net financing for 2024, coupled with stable corporate fundamentals, should support spread compression.

What could go wrong?

Given where sovereign and corporate balance sheets are, reflected in stable/improving ratings, the risks remain focused on global macroeconomic data. Recent weaker-than-expected US inflation and macro data supported the view the US Federal Reserve (Fed) will be able to deliver cuts later this year. This has reduced rates volatility somewhat, although markets remain sensitive to data surprises.

Although the supportive macroeconomic backdrop and ratings and technicals picture imply good prospects for carry over the summer, the focus will shift quickly thereafter to US elections. That complicates the picture for the impact Fed cuts could have. Cuts will help duration, but September is close to the November elections. The risk is that any rally in rates will be short-lived, given the likelihood that both presidential hopefuls will be in full swing on their policy agendas. With the current US debt/deficit levels, this could rattle rate markets. This suggests that the performance of high yield – less sensitive to rate moves – will remain a key return driver for EM credit.

Outlook

Global credit is vulnerable to geopolitical developments, and uncertainties continue. The Russia-Ukraine conflict is now in its third year with little clarity on a resolution. The Middle East conflict also continues, with material risks that it could escalate on Israel’s border with Lebanon. Markets, however, appear somewhat complacent towards escalation risks, suggesting knee-jerk reactions could be significant. Hence, we continue to monitor both conflicts closely.

Finally, what will also be supportive for sovereigns and corporates is the yield on offer for both – high single to low double-digits. This means it will take significant spread widening from current levels to offset the carry on offer. As such, we believe the high yield segment is on course to post total positive returns in the second half, building on its already impressive performance.

The above is an extract from our Q3 Active Fixed Income Outlook.

[1] Source: Bloomberg as at 19 June 2024

[2] Source: Bloomberg as at 19 June 2024

[3] Source: Bloomberg as at 31 May 2024

[4] Source: Bloomberg as at 31 May 2024