- Nominal EM sovereign yields fell to an all-time low of 4.34% last week
- Lower nominal yields since Covid driven by the risk-free rate as EM risk premium has widened
- We expect the prevailing tail-winds for EM to continue for a while yet, into the first quarter of next year
Nominal EM yields reached an all-time low of 4.34% on Friday on our calculations (EM US$ sovereign yield defined as EMBI spread plus US 10-year bond yield). This surpassed the previous series low on 3 January 2013 of 4.37%.
The yield has come down c40bps since end-October, buoyed by Joe Biden's victory in the US presidential election and positive news on Covid vaccines; although, if truth be told, we were near historical lows in August (4.38%) and have averaged c4.5% over August-October, making the November rally look less impressive. And yields were only 35bps wider at end-19. The new low also contrasts with the pre-global financial crisis low of 6.27% in April 2007, some 200bps higher, before the onset of post-crisis global easy money, something that is looking increasingly permanent.
The compression in EM nominal yields since Covid has been driven by the risk-free rate. US 10-year yields have declined by c110bps since the beginning of the year, from 1.92% to 0.83%. The EM risk premium, given by the EMBI spread, on the other hand, has risen by 74bps from 277bps to 351bps.
Moreover, if we compare the decomposition of the nominal EM yield at this low with the previous historical low in 2013, a similar picture emerges. Then, US bond yields were 1.91% and the EMBI was 245bps. Now, US bond yields are 0.8% and the EMBIG is 350bps.
This makes sense. The term structure of interest rates means that yields benefit from the post-Covid 'low for long' period of easy money, which looks set to stay for some time given the Fed's commitment to keep rates unchanged until 2023, while yields on longer maturities also benefit from the bond purchase programme. However, the post-Covid global shock has increased the EM country risk premium – as evident by the decline in credit quality signalled by sovereign rating downgrades (see here).
Borrowers rush in
It is therefore no surprise to see sovereign issuers seek to take advantage of this environment to lock in the low cost of long-term funding by borrowing in the international market. There has been a flurry of new issues in the last few weeks, after a relatively quiet few months, as borrowers take advantage of a year-end risk-on rally (see here).
But if the age-old question is whether low yields reflect fundamentals or technicals (search for yield, supply/demand imbalance), then a century bond from a country without a proper government (Peru) and a bond issue from a country with questions over whether the government is legitimate (Cote d'Ivoire), may give a hint at the answer, notwithstanding their still relatively robust credit metrics and fundamentals. The new US$1bn Peru 2121 priced to yield 3.278% while the EUR1bn Cote d’Ivoire 2032 priced to yield 5.0%. Cote d'Ivoire's planned bond (EUR benchmark WAL 10.2 years) is the first post-Covid Sub-Saharan Africa eurobond issue and the first SSA since February.
What is the outlook?
We expect the prevailing tail-winds for EM to continue for a while yet, into the first quarter of next year.
However, given the current low level of US bond yields (and barring a further negative shock), we suspect the balance of risks is tilted towards the upside (higher yields) than downside, especially in view of a possible US fiscal stimulus under a Biden-presidency (and his reported Treasury Secretary pick, Janet Yellen, an experienced policymaker and former Federal Reserve Chair who may favour additional government spending).
That means further EM yield compression will have to come from a narrowing of the EM country risk premium. This is possible in 2021, post-vaccine, through a continuing search for yield and cyclical improvement, although the structural damage wrought by the pandemic on many EM is still to be revealed and post-Covid fiscal consolidation will be a key challenge for many (see here).
Put another way, post-Covid, with higher public debt burdens, lower reserves, a lack of policy flexibility and concerns over hysteresis (economic scarring and structural damage to key sectors), how reasonable is it to expect the EMBI spread to return to 2013 lows of 250bps? Still, even 50bps lower spreads, bringing the EMBI more into line with its post-GFC floor of 300bps, would see nominal EM yields break through 4% (reaching 3.8%) assuming unchanged US yields. That would still represent a good performance for the asset class and no doubt fuel a further borrowing bonanza.
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