Trouble ahead – or opportunity? Quantifying the emerging market default cycle

 

A confluence of factors has led to the massive repricing of risk assets this year as investors fear a significant default cycle in the coming months. But what sort of losses can we expect?

To explore this question, we analysed the historical default rates and average recovery rates of emerging market (EM) corporates. We used J.P. Morgan’s proprietary data and Corporate Emerging Markets Bond Index (CEMBI Broad) for this analysis; we would like to thank YM Hong, Head of EM Corporate Strategy at J.P. Morgan, and his team for providing the data used for this analysis. Unless otherwise stated, all data within the following charts and table was access via Bloomberg as at August 17 2022.

 

EM corporate credit fundamentals and total returns

The table below provides a scenario for defaults and expected losses by rating categories:

CEMBI Broad default scenario over the next 12m

	Current yield	Expected loss	Recovery rate	Default rate
BBB	6.1%	0.5%	35%	0.8%
BB	7.5%	1.3%	35%	2.0%
B	11.5%	7.0%	30%	10.0%
CCC & below	22.9%	22.5%	25%	30.0%

Current yield as of 17^th August 2022

Please note the following regarding the default-adjusted returns analysis:

• Historical data since 2010 is used to estimate the average recovery rate and average default rates
• The default rates used in the analysis are close to each rating’s cycle peaks
• 35% is the average recovery rate for defaults over the last 20 years. We have used a more conservative figure for the lower-rated credits
• Actual results could differ from these estimates if the realised default and recovery rates vary significantly from our assumptions

The last point is important. For example, if the US and Europe slide into recession at the same time that China’s economy is weighed down by the property market slump, the macro backdrop is potentially very bad indeed. However, emerging market corporate fundamentals at least start off in a healthy state. Their net leverage (Net debt/EBITDA) is currently at 1.2x, the lowest since 2008 - as shown in the chart below. Similarly, EM corporates have a healthy interest coverage ratio of 10.5x, calculated as EBITDA / interest expense.

 

Moreover, valuations have already moved considerably to price in this pick up in defaults. Alongside the sell-off in US Treasuries, CEMBI Broad spreads have widened by 81 basis points (bps) this year, resulting in total returns of -13.87% YTD – the largest drawdown since the index’s inception in 2002. As a result, CEMBI Broad is currently yielding 6.9% (as of August 17, 2022), 40bps higher than the COVID-19 peak. Moreover, the current price of the index is $90.6, versus $96.3 at March-end 2020 – offering better convexity compared to the COVID-19 peak.

 

A favourable comparison

As the default table suggests, these yields compare favourably to the losses under our default scenario.

That said, yields often compensate investors for default risk (that has historically been the case for BBB and BB buckets, but not always the case for lower rated credit). Those investors who cannot close their eyes and hold to maturity will still be buffeted by price swings, but as this chart for BB rated bonds shows, the premium investors receive today is unusually high and should be a decent buffer for future volatility in our opinion.

 

 

Assumptions, opinions and estimates are provided for illustrative purposes only.

 

Forecasts are not a reliable indicator of future performance.