Fixed Income Boutique

Lagging emerging markets begin to catch up

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Luc D'hooge

Head of Emerging Markets Bonds, Senior Portfolio Manager


Market update

  • Emerging market sovereign spreads continue to tighten: Prior to the March market shock the EMBI was at a spread of 300 basis points then, with the onset of coronavirus lockdowns and the oil-price shock, spreads widened to 725 bps. Now, as markets have continued to calm, spreads have continued to tighten to around 520 bps now. Since our last investor call two weeks ago, spreads have tightened around 50 bps.
  • As we have previously indicated, EM has lagged developed markets, but the recent weeks show EM catching up.
  • Since the start of spread tightening on 23 March, EM sovereign investment grade has tightened 140 bps (vs. US IG: 180 bps), and EM high yield 290 bps (vs US HY: 430 bps). However, since mid-April, EM sovereign HY has been catching up with excess tightening since mid-April of 90 bps (EM HY 190 bps vs. US HY 100 bps).
  • So far, performance in May has been strong, with the benchmark now up over 6% (in USD), with HY outperforming IG (8.7% vs. 4.7%). On a regional level, Africa and Latin America are the outperformers (13% and 8%), with Asia lagging (2.5%), but we do see quite some dispersion between countries.
  • One of the drivers of EM spread tightening is the IMF opening up support to over 60 countries, this is a broad and reassuring move by the IMF. The liquidity injections by DM central banks (e.g., the US Federal Reserve and the European Central Bank), which resulted in a recovery and a bolstering of investor confidence can now be seen seeping through to EM.

Portfolio update and positioning

  • Latin America has recovered recently. However, when taking into account the average rating (BBB-), we feel Latin America has performed poorly overall, in our view, since the beginning of the crisis.
  • We maintain an overweight in Mexico as we find the sovereign spread attractive. We also perceive Pemex to hold good value.
  • In Brazil, we are underweight. We find the communications from President Bolsonaro on Covid-19 unproductive. Furthermore, our main concern is the president’s push for a spending spree, which we fear could derail the budget.
  • Looking at one of the more troubled issuers in Latin America, Ecuador is a country that was hit hard by the virus and oil-price shock, which was made worse by a landslide that cut off 95% of the country’s oil exports. It is likely, in our view, that Ecuador will require further restructuring. As a result of these fears, bond prices sunk very low; excessively so in our opinion and so we reinforced the position in the low 20’s. Since then, on growing optimism, prices have rallied around 30% in May.
  • Argentina also fell sharply through 2020 as the specter of default closed in, but has also rallied in a similar fashion to Ecuador in the past few weeks.
  • In Asia, overall, we are underweight. The reason is simple, in our view, with its well-developed capital markets and a broad market of high-quality names, Asia tends to somewhat expensive for our investment style, where we try to actively take advantage of mispricings.
  • Elsewhere, cash levels in the portfolio remain elevated as we continue to navigate uncertain markets. Africa has outperformed and so positions are being trimmed.
  • On a beta level, spreads have tightened but remain elevated and still lagging developed markets despite catching up since mid-April.
  • On an alpha level, there are still plenty of dislocations in the market, which allows us to stock up plenty of excess spread over and above the benchmark within the portfolio (nearly 3.5% in USD) due to the spread optimization approach, and that with an average rating similar to the benchmark.
  • Based on figures a week ago, the portfolio still has over 8% spread and a yield to maturity (YTM) of around 9% for a BB+ average rating. This, we believe, should provide a buffer in case of a return of volatility.

Outlook

  • Risk diversification and risk management remain key going forward. As markets have normalized somewhat, technicals are now better, so are flows, and primary markets are open for many issuers.
  • The opening of economies from lockdown is progressing well in both Europe and Asia. Tourism is looking to open again, progress will be slow, but this is none the less as important for many EM countries.
  • We see opportunities in relative value amongst issuers with some of the smaller and non-benchmark names trading at bargain prices, in our view.

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



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