In our view, numerous factors have continued to improve both market liquidity and market sentiment within the Emerging Market local debt asset class. Developed Market central banks providing market liquidity through their various liquidity facilities, as well as the purchase of investment-grade corporate bonds by some, coupled with the International Monetary Fund’s (“IMF”) emergency financing programs for specific countries, have all had a stimulative effect on Emerging Market local debt. Simultaneously, Emerging Market governments and central banks have also provided significant additional economic and financial support. This has been a beneficial development for the group, as economic crises throughout the years have helped Emerging Market countries improve their management of their public finances and debt levels. This in turn, has resulted in improved credit quality, public governance, and financial strength, creating economic resilience for (financially prudent) Emerging Market countries.
In spite of improved market conditions, we have noticed that the Emerging Market local debt markets are bifurcating – essentially splitting themselves into two distinct groups. On one side, you have Emerging Market countries with stronger economic fundamentals seeing their local currency bonds surge, as investors flock back into these securities, especially those with investment-grade status. On the other end however, countries with weaker fundamentals are seeing their sovereign and corporate bonds face elevated default risk, as market illiquidity and low investor sentiment plague their securities.
In June, we saw strong issuance of investment grade fixed income securities from B & BB-rated sovereigns and corporates. We expect this trend to further develop for the second half of the year, as an accommodative macro environment, including strong fiscal programs and increased market liquidity, green shoots sprouting throughout the global economy, recent weakness in the US Dollar, and promising signs of a COVID-19 vaccine, will all help be supportive to this asset class in our view.
As of July, Emerging Market local currency corporate bonds continue to tighten their spreads in relation to US Treasuries, but there have been some negative developments since the onset of the pandemic. Since the COVID-19 crisis began, we have seen a few Emerging Market corporate defaults so far throughout the space. Our view, is that given this uncertain environment, the default rate for this group will likely trend upward to high single digits throughout the remainder of 2020, as those industries particularly exposed to the COVID-19 crisis, such as retail, transportation, hospitality, and lodging, continue to remain under heavy bearish pressure. Nonetheless, even though spreads continue to tighten throughout the rest of the year, and into 2021, there will no doubt be bumps along the road.
New Life for Emerging Market Local Currency Debt
With the collapse of the US Dollar against major currencies in recent weeks, as well as the current accomadative monetary environment, new life has been breathed into Emerging Market local currency debt. In this article, we answer whether investors should pay attention to this area of the fixed income space.
Emerging Market Local Currency Debt Showing Signs of Life
The recent rally in Emerging Market local currency debt assets has gained investor interest following a record sell off in March stemming from the COVID-19 pandemic.
The simultaneous supply, demand, and commodity shocks stemming from the global lockdown measures that hit the global economy and financial markets, caused sudden and extreme outflows from Emerging Market local currency debt. This was seen across the board in this asset class, from individual Emerging Market local currency corporate and sovereign bonds, to exchange-traded funds, to investor redemptions from emerging market focused funds.
Market action in recent weeks has primarily been driven by global central banks, and their extraordinary liquidity facilities, which have helped keep the global financial markets from the abyss. Further, the recovery in the price of industrial commodities such as silver, copper, and oil, have also played an important part in the market rally, as well as in improving both investor and economic sentiment.
Given this backdrop, we consider both market sentiment and liquidity to be the key factors influencing the Emerging Market local currency debt asset class, creating opportunity for investors in our view. While the general trend since March has been a tightening of bond spreads, helped by improved trading conditions and increased market liquidity, market sentiment and liquidity remain pivotal factors. Their absence from the asset class has created significant volatility for Emerging Market local currency debt, but also opportunity as well.
Thus a patient and pragmatic approach is often needed to find hidden gems at attractive prices on a global, regional, and sector-specific basis.
A “See-Saw” Market: As Some Go Up, Others Go Down
In our view, numerous factors have continued to improve both market liquidity and market sentiment within the Emerging Market local debt asset class. Developed Market central banks providing market liquidity through their various liquidity facilities, as well as the purchase of investment-grade corporate bonds by some, coupled with the International Monetary Fund’s (“IMF”) emergency financing programs for specific countries, have all had a stimulative effect on Emerging Market local debt. Simultaneously, Emerging Market governments and central banks have also provided significant additional economic and financial support. This has been a beneficial development for the group, as economic crises throughout the years have helped Emerging Market countries improve their management of their public finances and debt levels. This in turn, has resulted in improved credit quality, public governance, and financial strength, creating economic resilience for (financially prudent) Emerging Market countries.
In spite of improved market conditions, we have noticed that the Emerging Market local debt markets are bifurcating – essentially splitting themselves into two distinct groups. On one side, you have Emerging Market countries with stronger economic fundamentals seeing their local currency bonds surge, as investors flock back into these securities, especially those with investment-grade status. On the other end however, countries with weaker fundamentals are seeing their sovereign and corporate bonds face elevated default risk, as market illiquidity and low investor sentiment plague their securities.
In June, we saw strong issuance of investment grade fixed income securities from B & BB-rated sovereigns and corporates. We expect this trend to further develop for the second half of the year, as an accommodative macro environment, including strong fiscal programs and increased market liquidity, green shoots sprouting throughout the global economy, recent weakness in the US Dollar, and promising signs of a COVID-19 vaccine, will all help be supportive to this asset class in our view.
As of July, Emerging Market local currency corporate bonds continue to tighten their spreads in relation to US Treasuries, but there have been some negative developments since the onset of the pandemic. Since the COVID-19 crisis began, we have seen a few Emerging Market corporate defaults so far throughout the space. Our view, is that given this uncertain environment, the default rate for this group will likely trend upward to high single digits throughout the remainder of 2020, as those industries particularly exposed to the COVID-19 crisis, such as retail, transportation, hospitality, and lodging, continue to remain under heavy bearish pressure. Nonetheless, even though spreads continue to tighten throughout the rest of the year, and into 2021, there will no doubt be bumps along the road.
“Through the Looking Glass” – Market Opportunities for Investors
Despite these rough patches, both Emerging Market sovereigns and corporates have been able to issue bonds, indicating there is still steady investor demand for this asset class. We must note though, that recent bond issuances and purchases have been predominately in the investment-grade space, and concentrated primarily in Asia – a trend we see continuing for the time being. We do see positive signs that many Emerging Market local currency issuers have been able to refinance at low rates, and draw on available credit lines, all of which has helped to enhance their liquidity positions.
It must be noted however, that in the interim, we do believe that some bonds have rallied too far, too fast. From a fundamental perspective, we do risk the prospect of a range-bound period of consolidation until the markets see further encouraging signs of an economic rebound. Questions surrounding valuations do remain over all asset classes in what has been a historic year for the global financial markets. We do expect more volatility over the coming months, but less so than what we saw in the first quarter.
Over the longer term, into 2021 and beyond, given that interest rates in Developed Markets continue to remain low for the foreseeable future, we do see Emerging Market local currency debt offering attractive opportunities to investors looking for additional yield over Developed Market bonds. We do recommend investors to stick with investment-grade Emerging Market local currency debt, but overall, we do believe that this asset class does offer opportunities for global credit investors.
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