Fixed Income Boutique

EM Bonds: sovereign and corporate debt update

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Luc D'hooge

Head of Emerging Markets Bonds, Senior Portfolio Manager

 

Market update

  • The crisis began with OPEC+ falling apart, followed by a big market correction with everyone running for cash. This resulted in both bizarre curve moves and spreads widening, with short-term bonds correcting to the same extent as longer-dated bonds, for example.
  • Negative basis has been observed in some countries such as Turkey as cash bond prices had reacted quicker than CDS prices.
  • Developed market central banks stepping in to provide liquidity tempered the dash to cash. This had a positive knock-on effect on emerging markets as investor confidence in finding liquidity was bolstered, decreasing indiscriminate selling.
  • With liquidity returning, the primary market began to recover and open up again with investment-grade issuers tapping the market. We see that the primary market is working quite well and it is a market that we find interesting.
  • Emerging market spreads remain wide. Although there has been tightening, emerging market spreads lag developed markets in this regard, which could be an opportunity.
  • The International Monetary Fund (IMF) recently downgraded its expectations for global growth. Emerging market growth, whilst revised negatively, has been revised down less than expected developed market growth.
  • We have observed downgrades as a result of the crisis (e.g., South Africa, Mexico, and Ecuador)

Positioning

Emerging markets debt portfolio

  • We have become a bit more defensive by reducing Africa (although we still like Africa), but we wanted to increase diversification
  • Spread levels exceeding the benchmark. The rating difference was half a notch below, but now 0.2 notches below, due to higher cash levels. .
  • In oil, underweight the sector (when comparing imports/exports of the countries as a share of GDP and their weight in the portfolio). However, exposure to higher beta oil exporters such as Angola and Ecuador.
  • In Argentina, the government has made a proposal on debt restructuring. In our view, the positive is that it includes a small haircut, with a negative that it includes a long period of no coupons or principal payments. We believe most investors are unwilling to take the current offer, which means there is a risk of hard default on May 22. However, with a slight adjustment to the terms, we believe bondholders may agree to an offer rather than let this go on and cause more tensions in the country. We have been reducing our position in Argentina, but the main reason is that we are finding better opportunities elsewhere.

Emerging markets corporate bond portfolios

  • Flows have been the main driver of prices recently. To understand flows into the emerging corporate asset class this year, we have to separate them to “pre” and “during” the crisis. Pre-crisis flows were positive, as was issuance. This is positive in the sense that many corporates have been able to front-load their financing needs. During the crisis, flows turned negative and the corporates correspondingly dialed down issuance levels. We have seen significant outflows from mid-February, with ETFs being one main conduit of outflows. Since April, flows have become more balanced. Now the market is tentatively opening with the higher quality issuers coming to the market.
  • Going into the crisis, we had built a higher cash position than usual, reducing the more event-driven exposures. More recently, we have started to move into more liquid, higher quality names, and taking part in some new issues that we felt were attractively priced. We believe that the higher quality names are the ones that should continue to rebound positively. Once investors become more comfortable with emerging markets again, then the less liquid issuers will also begin to see investor interest. When transpires, as we believe it will, we would then rotate back to this segment of the market.
  • The speed of adjustment we witnessed from mid-February to early April was fast, with lots of forced sellers in the market, meaning the fundamentals of many corporates are not reflected in the prices. In our view, as an asset class, the fundamentals are solid, but it does take time for firms to adjust (sell assets for example) and that doesn’t happen overnight. Oil exposure, for example, has been increased as we have sought to benefit from forced sellers.
  • The current yield in the portfolio is around 10%, with an average rating of B+. Overall, we have increased credit quality, but we see lots of downgrades in the market with many previous investment-grade issuers now below investment grade. As a result, our average rating has remained at this level, but credit quality has improved, in our view.
  • Over one year, the CEMBI GD index has delivered a slightly negative performance. However, breaking down the drivers of index performance, we see that the rates component has delivered double-digit positive returns whilst spreads have delivered double-digit negative returns. This illustrates why emerging market corporates have a firm footing in fixed income and is not an equity-like investment (although spreads and equity can be correlated). We see many corporate issuers that are not quoted (whilst most, if not all, quoted emerging market corporate have debt). Going forward, the contractual obligations of emerging market corporates to pay coupon and principal should provide support at a time when equity investors are further down the queue in terms of payout.

Outlook

  • In our view, recent events and the ongoing situation are much more of a liquidity crisis than a solvency crisis.
  • Commodity prices and de-globalization is a risk going forward. Supply chains will be more diversified in the future and this could be positive for some emerging markets, for example, Mexico could profit from this.
  • We remain confident in emerging market fixed income and believe that investor confidence will return, helped by the fact that the IMF should act as a lender of last resort.
  • In our view, and unsurprisingly, Covid-19 is what is causing the bulk of the current risks, affecting oil prices and, therefore, emerging market oil-exporting countries.
  • Remittances from emerging market ex-pats working abroad have dropped, as people are unable to work and send money back home. This may have an effect on some emerging market countries’ economies.
  • There will be many downgrades going forward and investors should not be surprised to see restructurings as well. However, the magnitude of the spread widening during recent months is similar to what was seen during the global financial crisis, which turned out to be a unique buying opportunity for long-term investors. When we compare yield right now to developed markets, the ratio has never been so elevated. With a zero yield environment in developed markets and spreads in emerging markets still wide, now may be a strong reason to step back into emerging markets. However, we believe that diversification is now key for investors, which means diversification across sectors and geographies.
  • The current level of yield income at the index level in itself is attractive and offers some protection to investors in the asset class. With the spread optimization approach, we aim to increase this level of spread for investors by exploiting segmentation and over-reaction in the market.
  • We still see volatility continuing, which should open up opportunities for truly active managers, who can aim to profit from the dislocations in the market.

For further information on performance and investment considerations regarding funds included in this Insight, please click on the respective "Related Funds" below.



Fixed Income Boutique
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