High Yield Part Returns to Emerging Markets Too Cheap to Ignore

High Yield Part Returns to Emerging Markets Too Cheap to Ignore

(Bloomberg) — The hunt for yield is back in emerging markets with a force not seen in 17 years.

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Investors are buying bonds from some of the world’s poorest nations so quickly that the risk premium on them is falling at the fastest rate since June 2005 relative to their investment-grade counterparts, according to data from JPMorgan Chase & Co. And countries that were on the verge of default just a few months ago – such as Pakistan, Ghana and Ukraine – are leading this high yield rally.

Before this month, the steepest selloff since the 2008 financial crisis had already had emerging market fund managers talking about the cheapness of high-yield bonds and how their underperformance relative to debt better rated constituted an unsustainable distortion. But bonds continued to be shunned due to a surge in US yields driven by the Federal Reserve’s aggressive monetary tightening. Only now, with the prospect of a slowing pace of interest rate hikes, are investors coming back.

“Cheaper emerging market high yield bonds look more attractive relative to investment grade,” said Ben Luk, senior multi-asset strategist at State Street Global Markets. The recent rebound in commodity prices, especially oil, could also “generate stronger cash flows and reduce near-term sovereign default risks.”

The extra yield demanded by investors to hold high-yield emerging market sovereign bonds rather than Treasuries fell 108 basis points in the month to 15, according to a JPMorgan index. The gap on a similar gauge for higher-rated debt narrowed only 23 basis points. That led to a narrowing of the spread between them by 85 basis points, the biggest monthly decline since the Fed raised rates eight times by a total of 200 basis points in 2005.

The outperformance of high-yield stocks comes as a wave of defaults predicted following Russia’s invasion of Ukraine has yet to materialize, with the exception of Sri Lanka. Most other nations continued to service their debts, with a few agreements reached with the International Monetary Fund. This made investors confident enough to return to bonds for their double-digit yields.

While dollar debt yields for Egypt and Nigeria have fallen since late October to around 13% and 12%, respectively, “distress risk is still heavily priced in,” Tellimer analysts wrote. in an email. The risk is mitigated in Nigeria by limited external write-offs in the coming years and in Egypt by the recent IMF agreement and currency devaluation, although their longer-term outlook is not favourable, they said. .

“Easing risk sentiment has opened a window of opportunity for some emerging market assets to outperform, particularly those that have sold off more than fundamentals would warrant,” wrote Stuart Culverhouse and Patrick Curran of Tellimer. in an email. “But some caution is still warranted in some of the most troubled stories, like Ghana and El Salvador, or where external financing needs are large and market access is limited, like Pakistan.”

Reopening of access

As capital markets have closed to the riskiest borrowers this year, some including Serbia, Uzbekistan, Costa Rica and Morocco could return to raise funds if yields fall further, Guido said. Chamorro, Co-Head of Emerging Markets Hard Currency Debt at Pictet Asset Management. Turkey sold bonds this month as the risk premium on its dollar debt fell to its lowest level in a year.

Yet smaller emerging economies still have a long way to go before achieving debt sustainability, and that could weigh on investors’ minds in 2023.

Credit ratings have plummeted in recent years as debt has risen and fiscal reserves have shrunk amid the pandemic and Russia’s invasion of Ukraine. In Africa, the Middle East, Latin America and the Caribbean, more than 50% of sovereigns are currently rated B or lower, according to Moody’s Investors Service.

This has increased the risk of default or restructuring among sovereigns with high funding needs over the next three years or large upcoming debt maturities relative to foreign exchange reserves, according to the ratings firm. The group includes nations like Ghana, Pakistan, Tunisia, Nigeria, Ethiopia and Kenya.

Yet the investor panic that pushed the spread between risk premia on high-yield debt and investment-grade debt to a record 890 basis points in July has eased amid a wave of IMF deals, bilateral financing commitments and hopes for a less hawkish federal government. Reserve.

A Bloomberg indicator of high-yield bonds in developing countries has risen about 7% since September, following five quarters of declines, in its longest losing streak on record. Average yields fell below 12%, after having exceeded 13% in October. That prompted Pictet Asset Management to become “more constructive lately” on the asset class, Chamorro said.

“There are some very attractive returns, especially if you can look through the periods of short-term volatility that we believe will still occur from time to time,” Chamorro said.

What to watch this week:

  • Turkey’s central bank is likely to lower its benchmark interest rate on Thursday for the fourth consecutive time, taking it to 9%

  • Israel is expected to raise its benchmark rate on Monday, extending its longest cycle of monetary tightening in decades to contain inflation

  • Policymakers in Nigeria, Kenya and Zambia will also set interest rates

  • Inflation data in South Africa will be closely watched for clues on the outlook for monetary policy

  • Thailand and Peru to report on gross domestic product

–With the help of Srinivasan Sivabalan.

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