Sovereign Analysis /
Global

EM credit sell-off unlocks pockets of value, but more pain could be in store

  • EM credit has sold off sharply this month amid rising US yields and EM spreads, with high-yielders leading the sell-off

  • EM spreads are still relatively well-contained despite rising global recession risk, meaning more pain could be in store

  • Sell-off has unlocked pockets of value in higher-yielding frontier markets, if investors can avoid default landmines

EM credit sell-off unlocks pockets of value, but more pain could be in store
Patrick Curran
Tellimer Research
20 June 2022
Published by

It has been a difficult month for markets with global stocks and bonds plummeting in tandem – the S&P 500 is down 11.1% and the 10-year US bond yields up 38bps in the month through 17 June. EM credit has consequently sold off sharply after a short-lived late-May rally, with the Bloomberg EM Sovereign Index falling 5.4% in total return terms amid rising US yields and 43bps widening of spreads. That brings the selloff to -19.4% (+105bps) ytd, on top of last year’s -2.3% (+39bps) performance.

At 442bps, the option-adjusted spread (OAS) on the Bloomberg EM Sovereign Index is now 67bps wide of the 375bps average in the 12 months pre-Covid and 205bps wide of the 10-year low of 337bps achieved in 2013. While spreads reached similar levels for brief periods in 2011 and 2016, it is also the highest spread post-GFC barring the two spikes after the outbreak of Covid and the Ukraine war, which may point to value in EM credit.

However, weaker fundamentals post-Covid (with higher debt burdens and lower growth projections) and a weaker external backdrop (with tightening global financial conditions and rising external financing needs) for many EM could justify the increase in spreads. Further, with spreads still well below the 2009 and 2020 highs of c875-925bps and the post-Russia/Ukraine spike of 483bps, there is still significant downside risk.

EM spread

The rise in yield has been even more substantial, exactly doubling since the end of 2020 to 7.76%. The increase was driven mainly by a sharp 244bps rise in underlying US yields, with spreads widening by a more subdued (but still significant) 144bps over that period. The yield increase has resulted in many EMs being locked out of the market, with 22 countries yielding over 10% by our count a month ago (not including the 5 in default) and subdued EM issuance in the 4 months to May.

EM yield

With US markets closed today, it is a good opportunity to take stock of EM credit performance by country. Excluding those in default (Lebanon, Sri Lanka, Suriname, Venezuela, Zambia) and those directly impacted by the war (Belarus, Russia and Ukraine), the worst performers mtd in spread terms have been Tunisia (+426bps), Kenya (+290bps), El Salvador (+283bps), Ethiopia (+251bps), and Ecuador (+224bps). The worst performers ytd have been Tunisia (+1516bps), El Salvador (+844bps), Pakistan (+764bps), Ethiopia (+705bps), and Ghana (+672bps).

Spread change

We find that the countries that performed worst over the first 5 months of the year have led the sell-off in June, with each additional 100bps spread increase through the end of May leading to an additional 25bps increase mtd (r2 = 35%, 99% confidence interval). Likewise, higher-yielding credits have been the clear underperformers ytd, with each 100bps difference in spread at the end of 2021 leading to a 45bps difference in performance ytd (r2 = 50%, 99% confidence interval).

Scatter1

Scatter2

These findings mesh with our earlier research that higher-yielding credits have tended to underperform during periods of weakness and outperform during periods of strength. This month’s sell-off also meshes with our view from early April that markets may be mispricing the extent to which the Fed will need to hike to tame record-high inflation and that relative stability in EM spreads was not consistent with the growing cocktail of risks (DM rate hikes, rising global inflation and commodity prices, global growth slowdown, higher global debt, geopolitical conflict, etc).

Indeed, markets have re-positioned sharply in recent weeks for a more aggressive Fed hiking cycle, with the Fed Funds Rate now projected to reach 3.6% by year-end versus just 2.75% at the end of May and 0.8% at the beginning of the year. As such, markets are now pricing in a more appropriately hawkish Fed policy stance, in our view. That said, amid a growing consensus that the Fed will be forced to push the US into a recession to tame inflation, this provides little solace for EM credit.

MIPR

The key question is whether or not we have reached an inflection point for EM credit. While markets have now priced in a more hawkish Fed, we think that more pain could be in store for EM assets amid rising recession risk and tightening global financial conditions, which will increase the risk of insolvency for many countries given the rise in debt vulnerabilities over the past decade and heightened external imbalances in many EM from elevated commodity prices and large external financing needs. In spite of these risks, the widening of aggregate EM spreads has been relatively modest this year, with spreads only c100bps wide of their 10-year average, meaning there is plenty of room for further weakness.

That said, the sell-off has likely unlocked pockets of value in some higher-yielding credits. We have flagged Egypt, Ghana, Pakistan and Kenya as Buy opportunities, while the sell-off in Nigeria may be cause to revisit our long-standing Hold recommendation and Tunisian bonds have been pushed close to recovery value. However, underperformance also reflects heightened vulnerabilities, and the risk of default will rise further if market access is not restored in time to avert a balance of payments crisis (most urgently in Pakistan, which will likely default if its IMF programme is not restored). Investors will thus need to tread carefully to avoid potential default landmines (like in Sri Lanka recently).