Why EM debt investors have to be picky

Portfolio manager highlights fault lines that will separate winners from losers, with one country standing out

Why EM debt investors have to be picky

The coronavirus crisis has created pockets of long-term opportunity for emerging-market bond investors, but they must also be mindful of the new fault lines and risks that define the fixed-income landscape.

In a new blog post, Tristan Sones, vice president and portfolio manager, co-head of fixed income at AGF Investments, noted that the impact of the pandemic on EM bonds has brought about attractive valuations, but the winning countries will be separated from others by a number of critical fault lines.

“Some Asian countries – most notably China, but also South Korea and Taiwan – were quick to implement containment protocols as well as fiscal and monetary stimulus,” Sones said, noting how such economies are poised to recover sooner than their slower-acting peers.

Closely linked to countries’ ability to respond, he said, is the amount of U.S. dollar-denominated debt they carry. The persistent strength of the greenback has resulted in massive currency devaluations in countries with high U.S. dollar debt, causing yield spreads between U.S. Treasuries and dollar-denominated E.M. debt to widen to around twice their pre-crisis levels.

“That represents a significant constraint on those countries’ ability to respond to COVID-19, as well as on their pre-crisis potential,” Sones said.

Developing countries that depend more on domestic debt, meanwhile, have seen their interest rates reduced by their respective central banks, which in turn has supported their bond prices. The upshot: a 3% reduction in prices of investment-grade EM debt year-to-date, compared to around 18% for traditionally high-yield EM bonds.

China deserves special attention, Sones noted, as its bond market has been well-insulated from currency fluctuations. It’s also in position to be a global leader in recovering from the crisis as its industrial capacity is already coming back online, and an increasingly domestic-focused economy that may get further stimulus from Beijng this year.

“Granted, full-year GDP growth in China will probably be a fraction of what it was in 2019, but at least it will be growth,” he said.

China’s outsized role in defining commodity prices, Sones added, means exporters like Brazil, Argentina, and Indonesia could “ride its economic coattails” in the post-COVID-19 world. In other words, China’s swift economic recovery could very well be the best hope for recovery among EMs around the world.

“One wildcard for emerging markets is the extent to which they will be able to tap into multilateral financial support to bridge them through the crisis,” he said. More than 90 countries have reportedly applied for assistance from the International Monetary Fund, and an IMF backstop could increase the appeal of certain EM bonds.


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