Near-zero yields are entrenched across the developed world. Fine-tuning around the edges of portfolio construction, or holding out in hope of eventual yield normalization is no longer a viable strategy to meet return targets.
Investors searching for more attractive yields are increasingly eyeing emerging market debt, a highly diversified and less-trafficked space with a solid risk-reward proposition. Yet, investing in this diverse terrain generally requires caution and expertise. This is especially true in the wake of the COVID-19 crisis, which has magnified many preexisting strengths and weaknesses across the asset class. Here we look at the dynamics driving the asset class, where we see opportunities, and potential pitfalls to watch out for.
A strong foundation provides resiliency
Strong economic fundamentals may provide a powerful driver for the emerging markets asset class. Most emerging markets entered the pandemic with moderate levels of leverage, manageable inflation, and limited reliance on external creditors. Much of Asia, anchored to China’s impressive recovery, has continued to expand. Other countries, notably Russia and Saudi Arabia, carry little debt relative to GDP, and therefore benefit from solid balance sheets. All remain highly creditworthy.
Underpinning these improved fundamentals is a growing self-sufficiency. For many countries, this includes a shift in the debt composition from external to local, more credible institutions (particularly central banks), the growth of local onshore asset managers, pension funds and insurance companies, and greater exchange rate flexibility.
The result: These strengthened economies may now have the financial flexibility critical to weather a possible prolonged recovery from COVID. For the first time, policymakers in a wide range of developing countries have been able to follow their developed market counterparts, allowing fiscal deficits to widen, easing policy rates, injecting liquidity into their financial systems, and even implementing quantitative easing. Historically, many emerging market countries were not able to use these tools because they weaken currencies, thereby exacerbating foreign currency debt burdens in local currency terms and giving rise to inflation.
For these reasons, we expect compelling loss-adjusted yields (i.e., yield minus defaults) in emerging markets, especially compared to more familiar sources of yield. In fact, our internal analysis indicates that the largest part of the compensation investors earn in emerging markets is for liquidity, complexity and unfamiliarity, not the risk of default. This is consistent with data from the ratings agencies and holds across the ratings quality spectrum.Footnotei It is also consistent with academic literature.Footnoteii We believe the potential to harvest this “excess over default” premium and compound it over time is powerful for investors looking beyond their home markets.
The specter of fallen angel risk appears limitedFootnoteiii
We have no doubt the pandemic has impacted all countries and that risks remain. Yet, while additional ratings revisions are likely, the bulk of agency downgrades related to the pandemic’s initial impact appear to have already occurred. PIMCO’s proprietary ratings system, which uses country-specific ratings risks in a forecasting model, indicates there are only a select number of countries likely to face a downgrade from investment grade to high yield and the subsequent forced selling pressure from investment-grade-benchmarked investors.
Other countries may remain solid investments even after suffering credit ratings downgrades. South Africa continues to deliver a steady 5.5% coupon despite a downgrade to high yield in March 2020. We believe these bonds remain quite attractive considering the country’s low external debt-to-gross domestic product (GDP) ratio of roughly 20%. Mexico and India both remain firmly in investment grade territory, although some ratings agencies have put them on negative watch, citing the pandemic’s impact on fiscal accounts. Yet we suspect that it would take several years of non-corrective behavior before they could be considered fallen angel risks.
But…beware of black holes
The benefit of diversification within the asset class comes with a caveat emptor – all sovereigns are not created equal. Thus far, the combination of savings buffers, multilateral (e.g., IMF) and bilateral (e.g., China) financing lines have helped many small, lower-quality frontier countries stay afloat. But a prolonged shock may result in permanent impairment and downgrades for which we don’t believe investors are adequately compensated.
Historically about one-quarter of emerging market bonds that suffer a price decline of more than 15% never generate any meaningful cumulative returns afterward.Footnoteiv This may be a bigger problem in coming years than it has been in the past considering that the public sector is looking increasingly for private sector involvement in debt standstills (i.e., suspension of debt service).
To protect against downside risk, PIMCO operates an early warning system for more than 70 countries, monitoring key credit parameters such as debt service costs, dollarization and de-banking trends, hard currency generating flows, remittances and tourism receipts, multi- and bilateral financing sources, and alternative policy options. Together with more traditional sovereign credit analysis, this early warning system helps us flag those bonds that are potential “black hole” risks – offering high yields but with the potential to pull in investor capital without return – allowing a deeper analysis of potential triggers and recovery values in the event of left tails. Our framework has currently identified 10 such countries, which yield an average of nearly 12%.
With yield scarce across the developed world, investors may have eschewed their traditional portfolio “home bias” – the behavioral tendency to overlook attractive opportunities in other countries in favor of investments closer to home – and become more interested in emerging markets. We believe this nascent trend is prudent as part of a comprehensive approach, and view emerging market debt as a compelling way to enhance diversification and benefit from excess credit premiums, as long as the appropriate guardrails are in place.
To learn about PIMCO’s sector-specific views within the emerging markets asset class, read “Emerging Markets Asset Allocation: Opportunities in a Time of Uncertainty”.
Lupin Rahman and Pramol Dhawan are portfolio managers.