- On Emerging Market Debt
- Reports of the Death of EM Debt Are Exaggerated
- Spreads are attractive compared with other asset classes.
- 2022-07-21 15:20
- Key Insights
- In a difficult period in financial markets, EM debt has been hit harder than other asset classes as risk‑averse investors have fled the asset class.
- History shows that EM drawdowns have often led to strong recoveries. Moreover, further potential sovereign defaults appear to have been priced in, helping to mitigate further downside risk.
- As such, we believe that EM debt spreads are very attractive by historical standards and represent a strong opportunity.
Emerging market (EM) bonds have been hit by their worst losses of the past decade amid deep market anxiety over looming rate hikes and the threat of global recession. The rolling 12‑month return of the JP Morgan EMBI Global Diversified, the benchmark index of dollar‑denominated EM sovereign bonds, was ‑21.2% at the end of June. Despite this, we believe that the asset class’s fundamentals remain strong—and that current spreads1 present a strong opportunity.
It has been a difficult year in financial markets. Rising inflation, stagnant growth, and the disruption caused by Russia’s invasion of Ukraine have piled pressure onto economies that had already been hit hard by the coronavirus pandemic. Stocks and bonds have tumbled in tandem, leaving investors with few places to shelter until the turbulence subsides. Emerging markets, traditionally viewed as a riskier asset, have taken a bigger hit than some other areas of fixed income.
Valuations Better Reflect Reality Than Other Markets
So why do we believe that now may be a good time to invest in EM hard currency sovereign debt? Well, experience tells us that sharp declines in EM debt have been a strong contrarian indicator for performance over the following 12 months. In other words, sharp losses have typically been followed by strong rebounds (Figure 1). Moreover, we believe that any EM sovereigns that are likely to suffer permanent capital impairment over the next 12 to 24 months have already been identified and priced in—put simply, we do not believe there are many overpriced EM sovereign bonds at present. If we are right, the current spread on EM debt looks very attractive relative to history.
"...sharp declines in EM debt have been a strong contrarian indicator...."
— Samy Muaddi, Portfolio Manager, Emerging Markets Bond Fund
Sharp EM Debt Losses Have Typically Been Followed by Rebounds
(Fig. 1) Sell‑offs have historically been a strong contrarian indicator*
As of May 31, 2022.
Past performance is not a reliable indicator of future performance.
* The spread/total return of the EMBI‑GD falling below zero has historically been a reliable indicator of double‑digit returns over one year.
† The excess return of the Index over US Treasuries.
EMBI‑GD = The JP Morgan Emerging Market Bond Index Global Diversified.
Source: JP Morgan (see Additional Disclosures).
Of the 21.2% decline in the EMBI Global Diversified, just over half (10.8%) derives from the rise in U.S. interest rates and the other half by worsening sentiment. Higher rates have meant that the yield available on EM debt is 2% to 3% higher than it was at the beginning of the year. So while rates are likely to remain elevated for some time to come (meaning any losses derived from rising U.S. rates will not be recovered in the near future), investors in EM debt are now getting a better return than they were just six months ago.
"...EM debt remains a somewhat stigmatized asset class...."
— Ben Robins, Emerging Markets Debt Portfolio Specialist
Sentiment is more temporary and, therefore, more likely to change in the near‑to‑medium term. Despite improving fundamentals, EM debt remains a somewhat stigmatized asset class—investors typically regard it as more dispensable than, say, U.S. high yield, and are more likely to dump it when things get tough. At present, for example, the markets are pricing in an increase in defaults in EM debt—around 35% of the option‑adjusted spread2 between EM debt and U.S. Treasuries derives from distressed bonds (Figure 2). By contrast, the U.S. high yield index spread contribution from distressed credit is close to a cyclical low.
Markets Are Pricing in an EM Debt Credit Cycle
(Fig. 2) Expected defaults are much higher than U.S. high yield
As of June 30, 2022.
Past performance is not a reliable indicator of future performance. Actual future outcomes may differ materially from expectations.
CEMBI: JP Morgan Corporate Emerging Market Bond Index, EMBIG: JP Morgan Emerging Market Bond Global Index, U.S. HY: US Corporate High Yield Bond Index.
Sources: JP Morgan and Bloomberg Finance L.P. Analysis by T. Rowe Price (see Additional Disclosures).
This does not necessarily imply that the markets are being overly negative about EM bonds; it does, however, suggest that there may be some lingering complacency toward other asset classes. While emerging markets have largely priced in the myriad risks to the global economy, it is possible that other markets have yet to fully absorb the bad news—or are benefiting from an assumption that central banks will cure all ills.
"We expect rate volatility to dampen before rates themselves come down...."
— Samy Muaddi, Portfolio Manager, Emerging Markets Bond Fund
It is difficult to have a strong conviction on the likely short‑term direction of interest rates given the current level of uncertainty over the global economy and financial markets. Recent data have surprised, and the Fed has proved itself nimble in responding to data. Accordingly, the MOVE Index, which measures bond market volatility, is currently just below 140, up from around 85 in January (it was below 60 in June 2021), indicating a high level of uncertainty in the path of rates. However, while more surprises cannot be ruled out, it is likely that we are closer to the end than to the beginning of the Fed’s hiking cycle. We expect rate volatility to dampen before rates themselves come down, which should be a precursor for a recovery in EM bonds.
Being Selective May Push Yields Higher
Overall, we believe that the current yield available on EM debt is a fair reflection of what an investor could earn. Valuations seem broadly accurate, meaning that downside risk is likely to be contained. Moreover, we believe opportunities exist for active investors to pursue yields above those available from the JP Morgan EMBI Global Diversified by being selective. For example, investors may consider avoiding both distressed sovereigns and the highest‑quality names and choose, instead, to seek overweight positions on high‑quality names that offer favorable yields and carry a low risk of default. In addition, countries that either have nonaligned foreign policy or whose foreign policies are aligned with those of the west carry less tail risk3 than those potentially subject to sanctions or vulnerable to being dragged into regional disputes.
1 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security.
2 Option‑adjusted spread is credit spread adjusted for any early redemption options.
3 The risk of loss from a rare event.
Bloomberg Finance L.P.
Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2022, J.P. Morgan Chase & Co. All rights reserved.
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The views contained herein are those of the authors as of July 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual outcomes may differ materially from any forward looking statements made.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. All charts and tables are shown for illustrative purposes only.
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