Emerging market debt, or EM, suffered a double blow in 2020 with the COVID-19 pandemic and the sharp drop in oil prices.
The double blow caused US dollar-denominated emerging market debt to fall behind the US bond market to return to pre-pandemic levels. But the widening of emerging market credit spreads indicates that investors are being rewarded with a yield premium for the increased risk of investing in these bonds.
However, taking a holistic index approach to emerging debt may not be the most profitable route. The pandemic has created idiosyncratic risks within emerging debt markets that make some countries more promising bets than others.
To learn more about the state of emerging debt and where advisers can look for the best opportunities, we spoke to Marcelo Assalin, portfolio manager of the William Blair Emerging Markets Debt Fund (ticker: WEDRX) and head of the William Blair’s Emerging Markets Debt Team. Here are edited excerpts from this interview.
How has the emerging market debt landscape been affected by the pandemic?
Initially, emerging debt credit spreads widened and bond prices fell, as the severity of the pandemic led to strict containment measures around the world, raising concerns about the potential impact on the global economy.
After a short period of high volatility, emerging market debt began to gradually recover following unprecedented policy responses – fiscal and monetary – in developed and emerging economies.
Strong support from multilateral organizations such as the International Monetary Fund, the World Bank and the G-20, in a context of very abundant global liquidity, has helped emerging market debt prices to reach pre-crisis levels. pandemic in early September 2020. Later in the year, the recovery gained momentum as COVID-19 vaccination programs began to be rolled out in advanced economies, opening up prospects for a strong global economic recovery.
You mention that the pandemic has created idiosyncratic risks and divergent perspectives in emerging markets. Can you explain what these risks and prospects are?
The severe economic impact of the pandemic has led to credit deterioration across the asset class. The collapse in economic growth had an impact on tax revenues, which in turn led to higher debt levels. Countries with stronger credit fundamentals, the ability to implement fiscal and monetary stimulus, easier access to finance, and strong relationships with multilateral and bilateral lenders have been better positioned to cope with the impacts of the pandemic.
Overall, countries have preserved their ability to continue to service their debt. However, we have seen a handful of countries with fragile credit fundamentals where the pandemic has accelerated debt restructuring processes.
Debt sustainability remains a major concern in a few places, but many of these bonds are already trading at troubled levels. And we believe that in almost all cases the salvage values â€‹â€‹are likely to be higher than what the market is currently valuing.
How should financial advisors manage these risks and perspectives when structuring client portfolios?
Emerging market debt is an asset class that lends itself to active management. Idiosyncratic risks and divergent perspectives create many opportunities for alpha generation.
However, it is essential to select an active investment manager with a proven ability to navigate these risks and opportunities, with a strong emphasis on risk management and diversification.
Why should advisors integrate emerging market debt into a client’s portfolio?
Emerging debt has the potential to improve the risk-return profile of a client’s fixed income portfolio. It has historically displayed low fault rates and high salvage values.
The asset class has evolved significantly over the years and today has over 900 issuers from over 90 countries, representing over a quarter of the global fixed income market.
At the same time, emerging debt is still under-owned and under-represented. Institutional investors remain under-allocated to emerging debt and the asset class remains under-represented in global bond indices. In turn, the asset class is undervalued in our view, and the risk premium overcompensates investors for the risks of volatility, default and loss upon default.
Where should financial advisors look for the best opportunities in emerging market debt today?
We believe that emerging market sovereign and corporate debt denominated in hard currencies, such as the US dollar, offers attractive value to investors.
While market conditions have normalized as the outlook for the asset class has improved, credit spreads remain above long-term averages, particularly in the higher yielding portion of the universe. investment, where the implied probabilities of credit default are in our opinion overestimated.
Zambia is a country that clearly suffered from debt sustainability risks before the pandemic, as the impact of COVID-19 clearly accelerated the process of debt restructuring. Bond prices have come very close to what we believe to be recovery values â€‹â€‹in recent weeks, following a positive result in the general election. Sri Lanka and Ecuador bonds continue to trade at troubled levels. Either way, the outlook remains very uncertain, but we see an opportunity in this space.
What are your predictions for the emerging debt market?
A positive combination of improving global growth and favorable liquidity conditions will continue to support investor sentiment throughout the year. In emerging markets, credit fundamentals are expected to continue to recover amid improving economic growth, increasing global trade and higher commodity prices.
While we believe US Treasury yields are likely to remain the main obstacle for emerging debt yields for the foreseeable future. We see limited scope for a significant increase in yields. We anticipate continued extraordinary monetary policy accommodation in the United States, as concerns about rising inflationary pressures will be eased by a slow recovery in employment.
In our view, technical conditions should also remain supported by positive investor inflows, net new issuance of contained debt, and strong inflows of nondedicated cross-investors attracted by favorable valuations of emerging debt relative to corporate credit. developed markets.
Hard currency valuations of emerging market debt remain attractive, particularly in the high yield bond segment, where credit spreads remain above long-term averages. These valuations are particularly attractive compared to US high yield corporate credit. We believe that sovereign credit risk premiums in hard currency emerging debt over-compensate investors for the risk of default and loss given default.
Overall, we see the possibility of compression in emerging debt risk premiums and expect tightening credit spreads to partially offset slightly higher yields on the US Treasury in the coming months.