2022 was one of the most disappointing years on record for fixed income investors, including those invested in emerging market debt. However, just one and a half months into 2023, we seem to be in a materially different world.

 

Looking at our investment universe, in the few months since the end of October 2022, EM corporate bonds have staged a vigorous rebound, with a healthy +10.1% total return. EM hard currency sovereign debt has performed even better, posting a +11.0% return over the same period.1

 

Indeed, part of this solid rally has come from what were substantially oversold conditions for fixed income, and emerging market debt more specifically. As always, we emphasise the importance of looking at the long-term attractiveness of the asset class – yield to maturity, spreads, and fundamentals. The technical picture also looks interesting, with very light positioning on the asset class from international investors and a lack of supply on the horizon.

Substantial shift in the macro backdrop
Of course, the rebound isn’t just a tactical story. In the last few months, the macroeconomic backdrop has substantially shifted, helping markets to regain confidence. Naming just a handful of well-known factors:

  1. “The disinflationary process has started” (cit. Chairman J. Powell): The US Federal Reserve (Fed) only acknowledged this event in its February meeting, while markets had acknowledged it much earlier, with the 10-year Treasury yield having rolled over 60bps from the 4.24% peak touched on 24 October 2022.
  2. Winter hasn’t come: A milder-than-expected start to winter allowed European countries some time to restore gas storages and avoid an energy crunch in 2023. This has (at least temporarily) removed a major risk factor for growth, especially in Europe.
  3. The great Covid-19 U-turn: China’s rapid re-opening surpassed even the most optimistic forecasts. While services are likely to be a major beneficiary, this also has strong implications for global economic growth and positive spillover effects for the EM complex. We expect China to be the global driver of growth again.
  4. Softer Fed means a weaker US dollar: US dollar dominance was one of the big stories of 2022, with negative consequences for external debt servicing for EM countries. A less hawkish Fed, paired with a lagging European Central Bank (ECB) and Bank of England (BoE), as well as surprises from the Bank of Japan (BoJ), have stopped the run for the time being.
  5. EM leading the cycle: Broadly speaking, EM central banks have shown a good level of credibility when facing this important test. After multiple rate hikes, many EM central banks have had the luxury of positive real rates on ex-post inflation. This allows some room for potential policy easing in 2023.
An everything rally
Solid starting conditions and positive macro forces have generated an “everything rally”, which has not only involved US Treasuries, but also credit spreads. Since the end of October 2022, EM corporate bond spreads have tightened by roughly 120bps, while EM hard currency sovereign debt spreads have tightened by around 100bps.2

Credit performance has been especially strong in those areas of the market that fell out of favour in 2022. In the EM corporate bond space, high yield (HY) spreads have materially outperformed investment grade (IG); as a result, the HY to IG differential has now fallen below historical averages.

The China reopening theme has been beneficial for Chinese corporate bond spreads (especially in the property sector), but even more so in Macau, where the gaming industry has finally seen the light at the end of the Covid-19 tunnel. Markets compensated this with a strong rally, as seen below.

Is this renewed bullishness sustainable?

When it comes to EM corporate debt, on a fundamental basis, we would say this “bullishness” is sustainable. Companies were already starting from a relatively good position in terms of their balance sheets. Furthermore, the more constructive macro backdrop is clearly positive for some of the weaker names that had started to appear more at risk in 2022. As a result, estimates for defaults have begun to come down quite meaningfully. JP Morgan now estimates a 5.5% default rate for EM corporate bonds this year, compared to rates of 10.6% forecasted just a few months ago (as a percentage of the EM high yield universe). This percentage falls to just 2.1% if Russia, Ukraine and the Chinese property sector are excluded from the universe.

 

The simple re-pricing of stressed/distressed names (like Macau) by itself is a clear factor that could justify the rally. Looking at sovereign debt though, the picture looks a bit more mixed. Lower rates and tighter spreads have provided a window for re-financing and maturity extension, but so far this has been mostly an IG story. Some HY debt remains in a weak position, and bond-by-bond analysis on potential recovery/exit value in the case of restructuring remains the best approach in our view.

 

From a technical perspective, we think the picture remains relatively positive. 2022 was essentially a year of closed markets, with very a low gross supply of both corporate bonds ($219bn) and hard currency sovereign bonds ($97bn). Flows were weak as well, with EM hard currency bond funds experiencing $44bn of outflows in 2022. Since the start of 2023, we have seen some recovery in gross issuance, with $46.6bn of hard currency sovereign debt issued in January, well above the historical average; however, at the same time, we also saw $31bn of EM corporate bonds being issued, which is well below historical averages. Prospects of issuance for the rest of the year remain relatively modest, with low to negative net issuance in both markets3 .

 

Many issuers have also been increasingly able to tap into the local markets, adding an additional source of financing, which is beneficial from both a technical and fundamentals perspective for external debt.

 

Finally, when it comes to valuations, there are various angles to consider. In terms of yield to maturity, EM external debt still looks attractive. To demonstrate this point, below, we compare it to the dividend yield of the MSCI EM Index, which is currently 3.6%:

As previously mentioned, spreads have rallied meaningfully, and the erosion in the value buffer between HY and IG is an important development. We think that there are still interesting opportunities available in the universe, but once again it’s become increasingly important to be selective.

Taking advantage of attractive opportunities
Given the less attractive premium on offer, in recent months, we have been starting to gradually reduce our HY exposure, while increasing our IG allocation. We have also decided to shift our exposure towards less cyclical businesses. We believe this is a great opportunity for us to improve credit quality without losing much on spreads.

Overall, we are positive about the outlook for emerging market debt, given fundamentals and valuations. Furthermore, last year’s indiscriminate sell-off has created a lot of attractive bottom-up opportunities, which we will look to take advantage of over the coming year.
Investment risks


Investment in emerging markets carries greater risk than investment in more traditional western markets. This may result in large falls in the value of the investments over short periods of time.


While high yield bonds may offer a higher income, the interest paid on them and their capital value is at greater risk of not being repaid, particularly during periods of changing market conditions.

1 Bloomberg, JPM CEMBI BD Index and JPM EMBI BD Index, US dollar terms, to 08.02.23
2 Bloomberg, JPM CEMBI BD Index and JPM EMBI BD Index
3 Source: JP Morgan, as of 31.01.23

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