High yield party returns to emerging markets too cheap to ignore

(Bloomberg) – Yield hunting has returned in emerging markets with a force not seen in 17 years.

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Investors are buying the bonds of some of the world’s poorest countries so rapidly that their risk premium has fallen at its fastest pace since June 2005, relative to its investment-grade peers, according to data from JPMorgan Chase & Co. And countries that were on the brink of default just a few months ago – like Pakistan, Ghana and Ukraine – are leading this rally in high yields.

Ahead of this month, the most brutal sell-off since the 2008 financial crisis, emerging market money managers were already talking about how cheap high yield bonds are and that their underperformance versus higher-rated debt is an untenable distortion. But bonds continued to be shunned on a rise in US yields triggered by the US Federal Reserve’s aggressive monetary tightening. Only now, with the prospect of slower rate hikes, are investors returning.

“Cheaper high yield emerging market debt is looking more attractive relative to investment grade credit,” said Ben Luk, senior multi-asset strategist at State Street Global Markets. The recent rebound in commodity prices, especially oil, could also “generate more cash flow and reduce the likelihood of a sovereign default in the near future.”

The additional yield that investors demand to own high-yielding emerging market government bonds instead of government bonds fell 108 basis points in the month to the 15th, a JPMorgan index showed. The spread, on a similar scale for higher-rated debt, narrowed just 23 basis points. This caused the gap between them to narrow by 85 basis points, the largest monthly decline since the Fed raised interest rates eight times in 2005, totaling 200 basis points.

The high-yield outperformance is due to the fact that a wave of defaults, which was forecast after Russia’s invasion of Ukraine, has not yet materialized, with the exception of Sri Lanka. Most other nations have continued to service their debts, with some deals being made with the International Monetary Fund. That has given investors confidence enough to return to bonds for their double-digit returns.

While dollar bond yields for Egypt and Nigeria have fallen to about 13% and 12% respectively since late October, the “risk of distress is still heavily priced in,” Tellimer analysts wrote in an email. Risk is mitigated in Nigeria by limited external paybacks in the coming years and in Egypt by the recent IMF deal and currency devaluation, although their longer-term prospects are not favourable, they said.

“Slacking risk sentiment has opened up opportunities for select emerging market assets to outperform, particularly those that have sold off more than fundamentals would warrant,” Tellimer’s Stuart Culverhouse and Patrick Curran wrote in an email. “But in some of the more distressed situations, like Ghana and El Salvador, or where there are large external financing needs and limited market access, like Pakistan, some caution is warranted.”

reopening of access

While capital markets shut down this year in the face of riskier borrowers, some, including Serbia, Uzbekistan, Costa Rica and Morocco, could return to raise capital if yields continue to fall, said Guido Chamorro, co-head of emerging market hard currency debt Pictet Wealth Management. Turkey sold bonds this month as the risk premium on its dollar debt fell to a one-year low.

However, smaller emerging markets still have a long way to go before they reach debt sustainability, and that could weigh on investors in 2023.

Credit ratings have fallen in recent years as debt has skyrocketed and fiscal buffers have shrunk amid the pandemic and the Russian invasion of Ukraine. In Africa, the Middle East, Latin America and the Caribbean, more than 50% of government bonds are currently rated B or below, according to Moody’s Investors Service.

That increased the default or restructuring risk of states with increased financing needs in the next three years or high impending debt maturities in relation to foreign exchange reserves, according to the rating company. The group includes nations such as Ghana, Pakistan, Tunisia, Nigeria, Ethiopia and Kenya.

But investor panic, which drove the spread between high-yield and investment-grade credit spreads to a record 890 basis points in July, has eased amid a spate of IMF deals, bilateral funding commitments and hopes of a less restrictive one Federal government cuts reservations.

A Bloomberg gauge of high-yield bonds in the developing world has risen about 7% since September after five quarters of declines that were the longest losing streak on record. Average yields have fallen below 12% after exceeding 13% in October. This prompted Pictet Asset Management to be “more constructive on the asset class of late,” Chamorro said.

“There are very attractive returns, especially when looking through short-term periods of volatility, which we believe will still occur from time to time,” Chamorro said.

What to watch this week:

  • Turkey’s central bank is expected to cut interest rates to 9% for the fourth time in a row on Thursday.

  • Israel will hike interest rates on Monday, extending its longest cycle of monetary tightening in decades to keep inflation under control

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

  • Inflation data out of South Africa are being closely watched for clues on the monetary policy outlook

  • Thailand and Peru will report on gross domestic product

–With the support of Srinivasan Sivabalan.

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