Macro Analysis /
Global

High-yield EM credit claws back losses but path ahead is perilous

  • EM credit has rallied since spreads peaked on 15 July, with the OAS on the Bloomberg EM Sovereign Index falling by 74bps

  • Spreads have fallen by 34bps for IG vs 174bps for HY, with the HY segment clawing back losses from previous sell-off

  • Volatility will continue amid rising recession risk and ongoing Fed hikes, with high beta for HY likely to continue

High-yield EM credit claws back losses but path ahead is perilous
Tellimer Research
24 August 2022
Published byTellimer Research

We last recapped the performance of EM credit on 15 July, which turned out to be the height of a sharp 101-day selloff that began in early April. Since then, EM credit spreads have contracted sharply (notwithstanding more recent weakness). From a peak of 506bps on 15 July, the option-adjusted spread (OAS) on the Bloomberg EM Sovereign US$ Index dipped to 399bps on 11 August. It has since given back some of those gains, reaching 432bps on 22 August, but remains 74bps inside of the mid-July peak. But on a ytd basis, the EM Aggregate has still widened by 95bps and sits 149bps above its post-Covid low and 65bps above the 2019 average.

EM index

High yield credits have led the rally, with the OAS on Bloomberg EM Sovereign High Yield Index declining by 174bps versus 34bps for the Bloomberg EM Sovereign Investment Grade Index. However, the HY spread is still 183bps wider ytd and sits a hefty 492bps above its post-Covid low and 610bps above the 2019 average.

Meanwhile, the IG spread has widened by a mere 12bps ytd and is just 21bps wide of its post-Covid low and is actually 5bps lower than the already subdued 2019 average. But despite the disproportionate selloff for the HY index, it has actually outperformed in total return terms. The EM Aggregate has returned -18.1% ytd through 22 August, with IG returning -18.8% and HY -16.9%.

EM credit

On a country-by-country basis, the credits that underperformed most severely earlier in the year have led the recent rally. Excluding Belarus, Ukraine, Lebanon and Suriname, each 100bps increase in the outright OAS on 15 July has translated to 20bps of additional spread compression since (77% r2, 99% confidence level). That said, higher-yielding countries have still underperformed ytd, with each 100bps increase in the outright OAS on 31 December translating to a 65bps of additional spread widening ytd (78% r2, 99% confidence level).

Scatter

Despite the recent rally, many HY credits remain locked out of the market. The number of index constituents with spreads >1000bps has fallen from 18 (27% of the index) on 15 July to 14 (21% of the index) on 22 August.

Likewise, the number of index constituents yielding >10% has fallen from a peak of 26 (39% of the index) to 22 (33% of the index) over that period. But while the yield on the HY index has fallen from 12.60% on 15 July to 11.09% on 22 August, this effectively means most HY countries are still unable to access the market (illustrated by the ongoing lull in issuance).

>1000bps

Moving forward, it is unclear if the mid-July to mid-August rally will be durable or if global recession fears and the ongoing Fed tightening cycle will cause risk sentiment to sour (which the more recent softness may indicate). The near-term forward spread (our preferred market-based recession indicator – see here for an explanation why) has flattened sharply in recent months and Bloomberg’s surveyed probability of a US recession in the next 12 months has continued rising to 50% from 35% in July and 15% in March, indicating growing fear of recession.

Near-term forward spread

Meanwhile, the market-implied Fed funds rate for end-2021 has stabilised around 3.5% since mid-June, and this month’s downside inflation surprise in the US (with July CPI falling from 9.1% to 8.5% yoy, below the 8.7% consensus) has lessened the risk of another destabilising upward adjustment to US rate expectations. However, markets have also notably revised previous expectations for a resumption of rate cuts by the Fed in 2023, with the market-implied end-2023 Fed Funds rate rising to c3.4% from c2.7% at the beginning of August.

MIPR

This adjustment meshes with our earlier view that a US recession is unlikely to trigger a reversal of the Fed’s hiking cycle unless it is accompanied by a more sustained decline in inflation and a sharp rise in unemployment, which remains near a five-decade low at 3.6% of the total labour force. While both survey and market-based indicators of inflation expectations remain subdued, the Fed cannot risk a de-anchoring of inflation expectations and, with the Fed funds rate roughly in line with the Fed’s estimated “neutral” rate, it is clear that more tightening is in store to exert downward pressure on core prices.

Breakevens

As such, if the US (or other advanced economies) dip into a recession then EM assets will likely be hit with a double-whammy of lower growth and tighter financial conditions. Against this backdrop, it is not clear that the recent rally will be sustained.

Further, with IG spreads still below pre-Covid levels (based on the 2019 average) and not far off from post-GFC lows despite tightening global financial conditions and a cocktail of risk factors (elevated global inflation, high commodity prices, geopolitical uncertainty and conflict, slowing global growth, etc), this segment of the index is looking expensive and could be vulnerable if risk sentiment begins to soften.

The high yield segment, meanwhile, will continue to exhibit an elevated degree of volatility, outperforming in a risk-on environment and underperforming sharply when risk-off prevails. While we continue to think that this year’s selloff has unlocked pockets of value, the underperformance of frontier markets versus their more established large EM peers is justified given rising external risks in the former versus more contained risks in the latter (a theme we discussed 18 months ago, when we flagged the relatively higher vulnerability of “fragile frontier” economies to Fed rate hikes).

With the recent rally not nearly sufficient to restore market access for most HY countries, the risk of default will remain elevated for credits with large gross external financing needs and limited access to financing. In many cases, the IMF and other multilateral and bilateral partners will need to step in to fill external funding gaps, but their ability and willingness to do so will be increasingly tested the longer countries are locked out of the market.

Overall, we are not yet convinced that the losses clawed back during the mid-July to mid-August rally will be maintained, with EM risk sentiment still fragile and subject to numerous risks. Further, some investors may take advantage of the recent rally to reduce positioning in some HY names that have seen the biggest bounce but remain vulnerable to a renewed tightening of global financial conditions.

With the August markets lull drawing to a close, it is still a tossup whether EM credit will rise or fall in the weeks and months ahead. The one thing that we can be certain of is that more volatility is in store and that frontier markets will continue to display the largest swings, creating elevated risk for investors that are overweight HY credits but also ample opportunities to generate alpha.

Related reading

The year so far in EM and frontier fixed income, July 2022

Taking stock of the EM credit rout, July 2022

Recession fixation is not reflected in forecasts and won’t impact rates yet, July 2022

What investors are thinking: Takeaways from our UK roadshow, June 2022

EM credit sell-off unlocks pockets of value, but more pain could be in store, June 2022

What rising US rates mean for EM assets, April 2022