The market has reversed since its dive in March, when emerging market (EM) hard currency spreads widened to over 700 basis points over Treasuries and now tightened to below 600 bps. However, EM bonds are still lagging developed market (DM) bonds in the pace of recovery, but starting to catch up. This is to be expected and provides us with opportunities as we expect the recovery to be slower but not weaker than in DM. So, there should still be time for investors to pick up bonds. Sovereign EM investment-grade spreads have tightened around 110 bps and EM high yield around 220 bps from their recent wides, compared to 160 and 360 in US investment grade and high yield respectively. This shows the slower recovery of EM bonds. However, the outperformance in the US was concentrated in early April. Since the end of April, EM sovereign high yield, for example, has tightened about 100 bps more than US high yield.
On a regional basis, Africa performed strongly in April. With Africa, it’s essential to stress the importance of bond selection, as the performance dispersion is broad. In April, for example, Angola is up around 15%, while Zambia is down around 14%.
Latin America was the EM laggard, net negative in April. Again, as in Africa, there’s strong dispersion with Argentina and Ecuador having lagged (but have both bounced back relatively during May to date) and Brazil sovereign suffering. With our lead-lag/rich-cheap approach, we are keeping a close eye on Brazil as a potential area where we could see recovery in the near term after recent overreaction.
Oil prices remain an important factor. We feel that investors recognize that the price of oil going into negative territory was a technical event and we see that confidence is now returning to oil names.
International Monetary Fund and World Bank action to support the poorest countries is positive, however, we perceived the communication as confusing.
Covid-19 remains the most important factor and the flattening of the infection curve is paramount to strengthening investor confidence in EM, which is still lagging DM, but the number of Covid-19 cases now appears to be decreasing, which is a positive.
Across the world, we are seeing an easing of lockdowns and reopening of economies and we expect this to continue. For example, China’s industrial production is now back, but they are struggling to find an export market. Retail/consumer confidence, however, remains weak. Economic numbers in Eastern Europe and Africa have proven to be better than expected, so that is a positive.
As EM sovereigns have recovered, we witness fewer opportunities, but an overall easier environment to execute trades.
Positioning and Performance
In effect, the above mentioned impacts our portfolios in the following ways: We are taking less concentrated positions, which means broader diversification.
We think there’s life in the rally yet, due to the recovery lag in EM vs DM, but we will take profits quicker and use the proceeds to increase diversification and move into more liquid positions.
We have maintained some cash positions in order to allow us to participate in opportunities as they arise, for example, in new issues.
In Argentina, we have been reducing our positions significantly, so our overweight in Argentina is now small.
We have partially shifted our Argentina exposure into Ecuador when it was under significant stress. We went into the latter at levels above 20 cash price and have been selling into the recovery at around 30. This profit taking is the result of the recent strong outperformance of Ecuador.
Lebanon is a negative contributor to performance this year. We bought some Lebanon bonds after the default and the resulting fall in prices, including at lows of around 12, as we felt Lebanon was trading at below recovery value. We have been selling at around 17. The country is in a difficult position and we don’t expect high recovery values, although the latter could be at levels above current prices.
The portfolio’s average rating is now closer to the benchmark, at 0.3 notches below. We are overweight in Africa, but this is likely to be reduced as the performance has been so strong. For example, we increased oil-related names in Africa during the big correction (Angola), which we have then been selling into the strength. To us, this makes sense as very depressed names went up quite a bit.
As of end of April, we have above 3.5% excess spread to the benchmark for nearly the same average rating. We believe that this is indicative of numerous mispricings in the market (potential alpha). Given the already elevated spreads in the market (beta), we observe a circa 10% total spread in the portfolio and thus an above 10% in USD YTM (end of April) and a BB+ rating. This should create a buffer for the volatility that we expect. As a reminder, US Treasuries are trading below 70 bps currently.
Economic numbers remain an important driver. We expect them to be poor in the near term, but improving towards the end of the year. This could open up the EM sovereign asset class to a strong recovery in 2021 due to the inviting spreads on offer.
The outlook remains improved, as the IMF is showing a willingness to support EM, this is often is followed by support from other countries.
The correction in March was extreme in EM, in our view.
Going forward we expect volatility and uncertainty to remain. Furthermore, we expect low yields in DM for longer and with such a situation in the US, the yield that you can get from EM should be tempting for many US dollar investors.
For further information on performance and investment considerations regarding funds included in this Insight, please click on the respective "Related Funds" below.