Yield hunting is back in emerging markets with a force not seen for 17 years.
Investors are buying the bonds of some of the world’s poorest nations so fast that the risk premium on them is falling at the quickest pace since June 2005 relative to their investment-grade peers, JPMorgan Chase & Co. data show. And countries that were tottering on the brink of default just months ago -- such as Pakistan, Ghana and Ukraine -- are leading this high-yield rally.
Before this month, the most brutal selloff since the 2008 financial crisis already had emerging-market money managers talking about how cheap high-yield bonds were and how their underperformance against higher-rated debt was an unsustainable distortion. But the bonds continued to be shunned because of a surge in US yields driven by the Federal Reserve’s aggressive monetary tightening. It’s only now, with the prospect for a slower pace of interest-rate hikes, that investors are returning.
“Cheaper high-yield emerging-market bonds do look more attractive relative to investment grade,” said Ben Luk, a senior multi-asset strategist at State Street Global Markets. The recent rebound in commodity prices, especially oil, could also “generate greater cash flow and lower the chance of any sovereign default in the near term.”
The extra yield investors demand to own high-yield sovereign bonds in emerging markets rather than Treasuries narrowed 108 basis points in the month through the 15th, a JPMorgan index showed. The spread on similar gauge for higher-rated debt narrowed only 23 basis points. That led to the gap between them shrinking by 85 basis points, the biggest monthly drop since the Fed raised rates eight times by a total of 200 basis points in 2005.
The high-yield outperformance comes as a wave of defaults predicted in the wake of Russia’s invasion of Ukraine has yet to materialize, with the exception of Sri Lanka. Most other nations have continued to service their debts, with some clinching deals with the International Monetary Fund. That’s made investors confident enough to return to the bonds for their double-digit returns.
While the dollar-debt yields for Egypt and Nigeria have fallen since late October to about 13% and 12%, respectively, the “risk of distress is still being heavily priced in,” analysts at Tellimer wrote in an email. The risk is mitigated in Nigeria by limited external amortizations in the coming years and in Egypt by the recent IMF deal and currency devaluation, even though their longer-term outlook isn’t favorable, they said.
“The easing in risk sentiment has opened up a window of opportunity for outperformance in selected emerging-market assets, particularly those that sold off by more than fundamentals would warrant,” Tellimer’s Stuart Culverhouse and Patrick Curran wrote in an email. “But some caution is still warranted in some of the more distressed stories, such as Ghana and El Salvador, or where external financing needs are large and market access is constrained, such as Pakistan.”
Reopening Access
While capital markets shut on the face of riskier borrowers this year, some including Serbia, Uzbekistan, Costa Rica and Morocco may return to raise funds if yields decline further, said Guido Chamorro, the co-head of emerging-market hard-currency debt at Pictet Asset Management. Turkey sold bonds this month as the risk premium on the its dollar debt fell to a one-year low.
Still, smaller emerging economies have a long way to go before achieving debt sustainability, and that could weigh on investors’ mind in 2023.