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EM Sovereign Credit: Five Reasons to Take Another Look

Despite recent price weakness in emerging market (EM) sovereign credit, GAM Investments’ Richard Briggs suggests the current environment could provide an attractive entry point for investors and highlights five reasons why he believes the long-term investment case for the asset class remains intact.

01 September 2021

EM sovereign credit (US dollar / euro denominated) has been a notable laggard in 2021, particularly relative to its developed market (DM) counterparts. This continued underperformance is especially striking given that the asset class has underperformed DM corporate credit persistently since 2018. With spreads on EM debt now considerably higher than on DM corporates as a result of this weakness, we expect that underperformance of EM credit to reverse in the years ahead. In our view, there are several reasons to be positive on the asset class.

Global growth at current levels would typically imply tighter spreads

Although the growth outlook may have moderated given renewed concerns driven by the Covid-19 Delta variant, global growth - even under pessimistic forecasts - remains at particularly strong levels. As an example, Chart 1 uses the China Manufacturing Purchasing Managers' Index (PMI) coupled with the US Composite ISM Manufacturing Index as a proxy for global growth. This average implies there is still a positive growth outlook, which would typically point to significantly tighter spreads than the current standings on JP Morgan’s EMBI Global Diversified (GD) Index.

Chart 1: Evidence for a positive growth outlook persisting

Source: Bloomberg, Markit, ISM, JP Morgan. Data from January 2010 to July 2021. Past performance is not a reliable indicator of future results or current or future trends.

2021 paints a different picture to the 2013 taper tantrum

2021 has repeatedly been compared to the 2013 taper tantrum due to fears that EM credit could be hit hard in the event of a sharp rise in US Treasury yields on the back of policy normalisation by the US Federal Reserve. But so far, they are almost incomparable. Even in the first quarter of 2021 returns on JP Morgan’s EMBI GD Index were below 4% after just three months. The negative total returns so far in 2021 (year-to-date 25 August) were driven by rising US Treasury yields, while spread returns have been positive for most of this year. This is in stark contrast to 2013 during which fears about credit risk drove spreads wider and US Treasuries caused a rise in yields. We believe that this was justified given the high liquidity concerns in 2013 due to large current account deficits and now, in 2021, generally the reserve cover of upcoming refinancing needs are significantly lower than they were back in 2013. In effect, the market appears far less concerned about the impact of rising US Treasury yields on credit risk in 2021 than it did back in 2013.

Charts 2 and 3: The 2013 taper tantrum versus the 2021 rates selloff (cumulative JP Morgan EMBI Diversified Total Returns)

Source: JP Morgan, Bloomberg. Data from April 2013 to August 2013 and from December 2020 to August 2021. Past performance is not a reliable indicator of future results or current or future trends. For illustrative purposes only.

Commodity prices are particularly supportive

Commodity prices, particularly oil prices, were hit hard early in the pandemic but have since recovered. In many cases, these prices are higher than pre-pandemic levels due to supply constraints and a sharp rebound in global demand. In our view, this is crucial given the high reliance on commodity exports for many issuers of EM US dollar bonds. Taking oil alone, almost 40% of the countries in JP Morgan’s EMBI GD Index are either oil net exporting sovereigns or bonds issued by state-owned energy companies. When looking at the oil-reliant sovereigns in EMs, we believe it is particularly important to pay attention to how their credit metrics would look at different oil prices and how resilient they would be to a prolonged downturn in oil prices. For example at the moment, while exporters will be supported at current oil prices, if prices drop sharply, the outcomes could be starkly different as some oil-exporting EM sovereigns would be hit harder than others. This theme is applicable across all commodities. Zambia is a key example of a country which has seen declining foreign exchange reserves persistently since 2015. This was in part due to copper prices being significantly below Zambia’s breakeven copper price. However, this has now reversed due to a rise in copper prices and a moderation in Zambia’s external breakeven prices.

Tourism is not a problem for the asset class as a whole

Tourism has been one of the most visibly impacted sectors due to Covid-19 and will continue to be due to the ongoing uncertainty surrounding the virus. For many EMs the pandemic has meant a large contraction in the US dollar inflows from foreign arrivals, particularly for those which ran large travel surpluses in their current accounts. In terms of magnitude, it is less important for most of the credit universe than it might initially appear, and certainly much less impactful than commodity exports which remain supportive. Where tourism is of greater concern, in our view, is in some smaller countries, such as those in the Caribbean, where tourism is a much larger share. Other countries that are also significantly impacted like Georgia or Croatia, relative to their reserves, are not as vulnerable as some of the Caribbean countries could be if low levels of foreign travel persist in the years ahead. Therefore, while tourism matters for some of the smaller issuers, the impact is relatively small for the asset class.

Chart 4: Largest pre-pandemic current account travel and tourism surpluses

Source: IMF, National Statistics Agencies. Annual data for 2019. For illustrative purposes only.

Eurobond rollover risk is low for most EM sovereigns

Fundamentals have been put under strain due to the crisis driven by Covid-19. However, near-term risks of refinancing crises driven by Eurobond maturities remain relatively low in most of the sovereign credit universe, mainly thanks to a significant terming out of maturities in recent years and sufficient reserve coverage relative to near-term refinancing needs. Eurobonds can often be a source of refinancing issues as they tend to be harder to roll over in a crisis than lending from other external, and particularly official, creditors.

We believe the support from multilateral and bilateral lenders (particularly the International Monetary Fund via its rapid financing facilities), explains a significant component of the reasoning behind why EM external defaults have been lower than many analysts expected over the past 12 months. In many cases, defaults and restructurings have focused on countries which already were expected to restructure prior to the pandemic, such as Lebanon, Argentina and Zambia, while Belize and Ecuador were two examples where vulnerabilities were high going into the crisis but the market was yet to price at levels which would imply the need to restructure.

Chart 5 illustrates the maturity schedule for EM sovereigns over the coming years. With a few exceptions, Sri Lanka being the most obvious, most countries have extended their maturity schedules by issuing long-dated Eurobonds in recent years, effectively pushing out the need to repay or refinance. This is in stark contrast to corporates where maturities tend to be more front-loaded.

Chart 5: HY Eurobond Maturity Schedule – HY EM Sovereign US dollar Debt

Source: JP Morgan Index data, Bloomberg. Data predictions of FY 2021 forward. For illustrative purposes only. There is no guarantee that projections will be achieved.

We believe the long-term investment case for EM sovereign credit remains clear. EM sovereign credit typically carries structurally higher spreads than on DM corporate credit despite typically higher recoveries in sovereign restructurings than on DM corporate credit and lower default rates within the asset class. In our view, the current juncture provides a particularly attractive entry opportunity into the asset class given low returns from DM debt, both corporate and sovereign, and excess yields on EM sovereigns – which are at their highest levels since the taper tantrum in 2013.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.

Richard Briggs

Investment Manager

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