Managers see opportunity in emerging markets amid pandemic

Emerging markets sovereign debt is coming into favor among money managers, as these coronavirus-ravaged countries look to be at their most attractive valuations in more than a decade.

Money management executives are largely putting risk back on the table, taking advantage of cheap assets and high-quality sovereign issues. At the same time, they're taking some comfort in pledged support by global organizations, including the International Monetary Fund.

"Valuations in EMD are the most attractive they have been since the global financial crisis" in 2008-'09, said Raza Agha, London-based head of emerging markets credit strategy at Legal & General Investment Management. "Current spread levels were last seen around mid-2009."

Emerging markets are set to contract by 1% in 2020 before rebounding 6.6% next year, according to IMF projections published in April. The MSCI Emerging Markets index was down 17% for 2020 through April 30, while the J.P. Morgan Emerging Markets Bond index returned -9.82% for the same period.

Asset flows reflected a difficult March and April. Emerging markets debt strategies saw $41.1 billion in net outflows this year through April 29, with about $55 billion in net outflows over March and April, show data by EPFR Global, part of the financial intelligence division of Informa PLC. Emerging markets sovereign debt strategies recorded $13.7 billion in net outflows for this year through April 29, with about $18.6 billion in net outflows in March and April.

Large outflows over recent weeks "brought valuations to extremely distressed levels," said Gustavo Medeiros, deputy head of research at Ashmore Group PLC in London. J.P. Morgan EMBI Global Diversified index spreads jumped to 720 basis points over U.S. Treasuries at their peak from around 300 basis points before the crisis hit, with a recent rally bringing spreads back to around 640 basis points, he said. And emerging market high-yielding bonds are now trading "at a very dislocated" 1,100 basis points over U.S. Treasuries, having hit 1,200 basis points at one point.

Despite overall outflows, some long-term institutional investors are sticking with emerging markets, and even committing more capital at the margin. "However, we know there is a large amount of crossover investors that feel an irresistible urge to dump EM assets at whatever opportunity they can. Hence, overall, EM has experienced large outflows" since the triple shock of the coronavirus crisis, plummeting oil prices and a stock market correction, Mr. Medeiros said. "More recently, proxy flows to mutual funds suggests the situation has stabilized. We believe (the) technical position is much better now and the same long-term investors that remain committed to the asset class will find good opportunities to add into tremendous value over the coming quarters." Emerging markets specialist Ashmore runs $76.8 billion in assets.

Some money managers also added risk. First State Investments executives were "reasonably lightly positioned in risk" at the start of the year as emerging markets spreads "offered only a modest buffer to compensate investors for potential market volatility," said Amalia Nunez, investment director for fixed income and multiasset solutions in London. "While COVID-19 does present a fundamental challenge for a number of EM countries, in many cases we believe valuations have overshot the longer term fundamental reality, and we used March's dramatic price drop as an opportunity to invest in credits at fundamentally compelling valuations." The First State Investments emerging markets and Asia fixed-income team has $4 billion in assets under management.

From a valuation perspective, emerging markets sovereign debt is "very attractive," said Marcelo Assalin, London-based head of emerging markets debt at William Blair & Co. LLC. "We have a bias toward increased exposure to high-beta, high-yield countries, where the average bond price is compelling." Countries include Argentina, Ukraine and Tajikistan, he said.

The implied probability of a default in these assets is "unrealistic, and there is significant price dislocation created by indiscriminate, forced selling of exchange-traded funds," although that "should be corrected once market conditions normalize," he said. An assets under management figure for the team, which joined William Blair late last year, is not yet available.

Adding some comfort to increased sovereign debt risk in portfolios is the $1 trillion in lending capacity of the IMF and the World Bank, the granting of debt relief by Group of 20 nations to emerging market countries and the temporary extension of dollar swap lines to certain emerging market central banks — including Brazil and Mexico — by the Federal Reserve.

"The role of international financial institutions ... and bilateral donors (such as China) should be critical in providing short-term relief," Mr. Assalin said. "These measures should help contain a debt crisis in EMs."

And the IMF's support for emerging markets governments will come into play as the dollar strengthens — thereby increasing the burden of dollar debt on these countries. "The IMF has the resources, the expertise and, most importantly, the credibility to help the most vulnerable countries," First State's Ms. Nunez said. The MSCI Emerging Markets Currency index was down 5.42% for the year through April 30.

However, "while these measures are supportive and much needed, there are still doubts about whether it is enough," said Anupam Damani, New York-based portfolio manager at Nuveen LLC. Ms. Damani runs the $404 million TIAA-CREF Emerging Markets Debt Fund. "While interventions have certainly helped alleviate pressure, more relief is desperately needed for many EM economies."

And it may not be a simple process. The IMF "has some ability to provide modest amounts of rapid support, but it's important to appreciate it was not set up as lender of last resort, nor is it well-positioned to act quickly and holistically," said Angus Bell, London-based senior portfolio manager in emerging market debt at Goldman Sachs Asset Management. "With still such enormous levels of uncertainty on the outlook for many EM countries, the fund's ability to analyze debt sustainability with any accuracy is clearly challenging." GSAM manages $40 billion in emerging markets debt.

While money managers are used to assessing factors such as the impact of the oil price on emerging markets, the coronavirus-related crisis has pushed them to create new splits when seeking investment opportunities.

"EM sovereign debt issuers have approximately $117 billion due to mature" this year, with about $75 billion of that total coming from central and Eastern Europe and the Middle East including Qatar and Saudi Arabia — "notably countries that, in essence, can afford to pay," said Polina Kurdyavko, London-based partner, senior portfolio manager and head of emerging markets at BlueBay Asset Management LLP.

Countries in sub-Saharan Africa are due to refinance about $10 billion, although the region represents a small percentage of the asset class. "We hold a more cautious stance on this region and have been positioned underweight since the beginning of the year, reflecting our concerns around debt increases and certain governments' inability to deal with a downturn in growth. We would expect to see more pain and possible restructuring in this region," Ms. Kurdyavko said. BlueBay manages about $8.5 billion in emerging markets debt assets.

Barings executives have started splitting emerging markets countries into two broad buckets as a result of the COVID-19 crisis, said Cem Karacadag, Boston-based head of emerging markets sovereign debt. "The bigger and investment-grade-rated countries have responded to the crisis in similar ways to developed markets," helping small businesses and increasing transfers to vulnerable households. "They are also raising funds in the external markets, which have stayed open for investment-grade names," with Mexico, Peru and Panama among the names issuing debt in recent weeks.

At the other end of the spectrum are countries relying on the IMF, World Bank and other lenders such as the European Union and China. These economies include those relying on tourism and oil, such as Greece and the Central American countries, Mr. Karacadag said.

Executives at Barings focus on liquidity in the near term and debt sustainability in the long term. "Our second main focus has been on willingness to pay, given the human and political dimensions of the crisis, and the fact that official lenders are explicitly calling for private creditors to provide debt relief. This makes our jobs harder and more of an art than science than it has ever been in our careers," he said. Barings has $9.6 billion in emerging markets debt AUM.

Credit selection will become "more important going forward, to determine which countries and corporates can cope with the new after-COVID-19 environment, and the gap between good and bad creditors will remain huge," said Sergey Dergachev, Frankfurt-based senior portfolio manager at Union Investment Institutional GmbH. "What makes EMD attractive for investors is that spreads capture political and liquidity risk, and for long-term investors now it is (at) an attractive level." Mr. Dergachev warned, however, that the market environment remains volatile "and can be for some time ... valuations look very attractive, but short-term spreads can still widen somewhat, but then a good entry point will exist," he said. Union runs about €13 billion ($14.3 billion) in EMD strategies.