After a Challenging 2022, What’s Next for Emerging Market Bonds?
It’s been a challenging year for emerging markets, which faced tighter financial conditions and growth headwinds from the war in Ukraine and China’s property sector. Bond markets in lower-quality developing countries have been hit especially hard amid rising interest rates. We spoke with Kay Haigh, head of emerging market debt in Goldman Sachs Asset Management, and Nick Saunders, head of emerging market corporate debt, about challenges and opportunities posed by a new era for financial markets — one in which easy policy is no longer around to lift all assets.
What are the key issues facing EM economies?
Kay Haigh: Emerging market debt loads have risen sharply in response to both the pandemic and cost-of-living crisis, resulting in weaker fiscal positions. At the same time, the reopening of these economies and the energy price shock have led to a deterioration in current account balances. Given the outlook for weaker growth, it’s likely to take longer for EM economies to see an improvement in fiscal and current account positions, even for net commodity exporting economies.
Against this backdrop, a sharp rise in U.S. rates and the U.S. dollar has raised concerns over external vulnerabilities and debt sustainability, both of which can ultimately threaten economic stability and weigh on EM assets. Given the economic concerns and sharp outflows from the asset class, spreads on the external EM debt benchmark have widened materially this year.
So which economies may struggle to raise capital over the coming year?
Kay Haigh: Certain lower-rated EM economies have already lost access to external bond markets, challenging their ability to meet near-term external and fiscal needs, and repay upcoming debt maturities. Looking ahead, from the perspective of currency reserves relative to external financing needs, Pakistan, Sri Lanka, Bolivia, Argentina, Angola and Egypt are among the most vulnerable. From the perspective of high debt loads and high-debt servicing costs, Egypt, Ghana, Sri Lanka, Ukraine and Zambia are among the most challenged.
If these economies cannot access capital markets, what are the alternatives?
Kay Haigh: The good news is that EM economies have two key alternative funding sources to global capital markets: bilateral lenders and the International Monetary Fund. The bad news is that securing financing from both sources is proving challenging. China is the leading bilateral lender to EM countries, particularly to lower-income countries, but funding from China has slowed in recent years. G20 countries established a “common framework” for debt relief in 2021, which China joined. However, debt restructuring under this framework has been disappointingly uncommon.
Do these challenges and vulnerabilities suggest an EM crisis is looming?
Kay Haigh: The short answer is no. Our analysis shows that EM countries’ vulnerabilities are isolated, not broad-based. Excluding sovereigns in distress, EM sovereign bond spreads are broadly unchanged year-to-date and have outperformed similarly rated U.S. corporate bond spreads. We believe this reflects economic resilience among middle-income, often larger, EM sovereigns. For example, the five largest countries in the external emerging market debt index by GDP – Brazil, China, India, Indonesia and Mexico – do not appear at risk of an external crisis.
Importantly, risks are largely confined to smaller low-income countries and are already largely reflected in bond valuations. Risks stemming from two large sovereigns that are in distress – Argentina and Turkey – are also well known and in our view, priced in. We think the market will continue to differentiate to preserve funding for higher quality (and often larger) economies with deep trade and financial linkages globally. In other words, we do not expect contagion from pockets of vulnerabilities to resilient EM sovereigns or broader global financial markets.
Nick, how are EM corporates navigating the macro headwinds?
Nick Saunders: EM corporate bonds have not been immune to the selloff in 2022 but, like the sovereign bond space, weakness is idiosyncratic, not broad-based. Overall, the EM corporate bond index is down around 12% so far this year.1 The weakness is largely driven by Russia – where corporates have underperformed amid economic sanctions in response to the war in Ukraine – and China’s hard-hit property sector. Excluding Russian corporates, performance is better than U.S. investment grade credit and closer to the U.S. high-yield credit market.
How should global investors consider EM corporates as part of their fixed income allocations?
Nick Saunders: The market is skewed toward investment-grade bonds with an average rating of BBB, meaning EM corporates can complement developed market corporate bond allocations or EM sovereign bond exposures. We believe EM corporate bonds are an attractive asset class for retail and institutional investors looking diversify existing bond allocations.
Where are the opportunities in EM corporates?
Nick Saunders: We see value in recession-resistant, non-cyclical sectors such as food and beverages where companies benefit from strong brand recognition and customer loyalty. We also see structural growth potential in companies aligned to secular themes like the energy transition, such as Indian renewables. And we are overweight domestically oriented banks—operating in countries such as Mexico, Colombia, and Israel—that have traditional lending models, strong capital positions and strong net interest margins. Across Latin America, we see investment potential in bonds issued by airports.
Kay, what about EM sovereigns?
Kay Haigh: As we move into a new era for financial markets — one in which easy policy is no longer around to lift all assets — we expect greater opportunities for alpha generation through active management. It may take time for value to be unlocked in distressed external EM bonds given lengthy restructurings; however, we expect higher yields in resilient sovereigns to offer opportunities to generate positive total returns. Meanwhile, local EM bond market opportunities may open up as EM central banks near the end of their hiking cycles or even begin to consider monetary easing.
Overall, we see value in being selective, paying close attention where sovereign bond restructurings have potential to progress or where economic fundamentals are not reflected in market valuations.
Any particular areas you’re focused on?
Kay Haigh: EM economies still have productive investment opportunities that have yet to be exploited, including those linked to the energy transition and digitization as well as traditional growth areas such as serving the consumption needs of a rising middle class and infrastructure development.
One key opportunity is green bonds issued by EM borrowers. An estimated 98% of global population growth and 90% of new middle-class household formation in this decade will be based in EMs. The increase in energy demand that will accompany this development means the adoption of clean energy innovations across the EM world will be critical for achieving the Paris Agreement.
In this regard, green bonds, where proceeds are used to finance climate- or environment-related projects, assets or activities, may be both a useful tool for bond issuers looking to finance green investment and bond investors looking to align financial performance with sustainability goals. In short, global investors can potentially still earn an attractive rate of return through investments in EM bonds, tapping into growth potential and economic transformations.
1. Source: J.P. Morgan, as of December 7, 2022.