Sorting through emerging-market debt opportunities
Local-currency emerging-market (EM) sovereign bond total returns have improved since April due to yields falling and EM currencies rising against hard currencies, although they have still fallen in value year-to-date in general. After spiking in March, average EM local-currency sovereign yields have fallen back to lows of 4.5% (on 5 June), helped by EM central bank monetary policy easing and the Fed’s liquidity injections (swap lines and repurchase agreement operations).
Investors continue to discriminate, with sovereign yields remaining wider in countries at risk of financial turmoil such as Turkey, South Africa and Brazil, and also in countries where central banks have more room to cut rates, like Mexico. This accommodative stance is being sustained by the global fall in inflation resulting from lower oil prices. This has made real yields look attractive in South Africa, Indonesia, Mexico, Brazil and Russia.
Facing an economic crisis, many EM central banks have been acting more responsibly and more creatively than in the past, limiting foreign exchange interventions to sustain their currencies, cutting policy rates to support their domestic economies, and some (such as Brazil, South Africa and Indonesia) even launching quantitative easing (QE) programmes to buy their own government bonds. In other words, many have followed their developed-market (DM) counterparts’ rule book.
However, strains on government finances mean that further rating downgrades are likely for many EM sovereigns, with India and Mexico particularly at risk of becoming fallen angels (downgraded from investment grade (IG) to high yield (HY)) over the coming two years. Turkey, South Africa and Brazil could fall deeper into HY.
We remain neutral on local-currency EM sovereign bonds, with yields unlikely to fall much lower. We have a year-end yield forecast of 5% for the JP Morgan GBI-EM Global Diversified index as we believe most additional policy rate cuts have already been priced in, while a rising risk premium in some countries could counterbalance the likely downward pressure coming from China’s inclusion in this index.
We remain neutral on hard-currency EM corporate bonds, still favouring investment-grade (IG) companies, as spreads remain wide compared with those of their DM counterparts, probably due to sovereign risk. By contrast, EM HY spreads are close to those of US HY, with a similar expected default rate risk, but with the additional risk of sovereign rating downgrades. This makes EM HY look less attractive.