Commentary: Despite chance of emerging markets debt restructurings, opportunity exists

Historically, sovereign defaults in emerging markets debt have been rare events, and the combination of high yield and minimal default risk has led emerging markets debt investors to enjoy strong returns. However, 2022 has seen investors pull billions from emerging markets bond funds as concerns mount about the future returns of emerging markets sovereign debt. Rate hikes in developed markets, notably in the U.S., and a subsequent reduction in the Federal Reserve's balance sheet have led some investors to believe that emerging economies, which have suffered from a cacophony of headwinds — including soaring global inflation, tightening central bank monetary policy and Russia's invasion of Ukraine — could be entering a period of less favorable returns.

This could reduce access to the market for lower-quality emerging markets debt investors, which in turn may cause a flood of defaults and restructurings. In addition, the World Bank has stated that it expects a "coming spate of debt crises" in emerging markets and of course, we have already seen defaults from Zambia, Lebanon and Argentina in 2020 and Sri Lanka in 2022. Makes for grim reading I know, but, on the upside, we believe these risks are already priced into the market and that there is a compelling case for investors to hold their nerve in emerging markets debt.

Despite an elevated number of restructuring candidates, there are reasons to be optimistic about the potential impact on future asset-class returns. A sovereign default with a low recovery value can adversely affect a country's ability to access international capital markets, expose the country to litigation and impair its citizens' standard of living. Therefore, it is generally in a sovereign issuer's best interests to reach a benign settlement agreement with creditors. Investors can also be comforted by the multilateral support a sovereign issuer is likely to receive in order to improve current and future debt sustainability. Multilateral and bilateral support for emerging markets suffering economic difficulty is extremely high, with the International Monetary Fund alone currently providing about $250 billion of support. And that is only a quarter of the IMF's $1 trillion available lending capacity. There is help available should more emerging economies need it. Secondly, aside from 2020, when emerging markets sovereigns experienced a relatively high level of restructurings, historical defaults and restructurings in emerging markets debt have been extremely low. This has been true even during previous Fed rate-hiking cycles, which have not caused a glut of defaults.

Moreover, when restructuring has been necessary, recovery values have averaged 55 cents on the dollar, a level far higher than that of corporate bonds. At this moment already, a lot of distressed bonds are trading around or below the average recovery value. The J.P. Morgan Emerging Market Bond Index Global Diversified is also more diversified in 2022 than it was in previous Fed rate-hiking cycles, reducing the concentration risk of an isolated default.

When analyzing the returns of emerging markets debt in the year following previous Fed rate-hiking cycles, we do not believe that investors should be overly concerned. Although each cycle we analyzed involved unique global economic factors, emerging markets debt returns in the 12 months following the start of a rate-hiking cycle have been strong, as the table below shows. Double-digit returns of 14.67%, 18.44%, and 10.15% were recorded 12 months after the first-rate hikes in 1999-2000, 2004-2006 and 2015-2018, respectively. And in each instance, spreads tightened into the hikes.

In each of the past rate-hiking cycles we examined during the life of this asset class, high-yield emerging markets debt has outperformed investment-grade emerging markets debt in the 12 months following the first Fed rate hike. We expect the current tightening cycle to be no different. The high-yield/investment-grade spread differential is trading at historically wide levels. Also, cash prices are low across the asset class, and the number of bonds trading at distressed levels has already reached an all-time high, with prices of C-rated bonds already averaging in the mid-$30s, which is well below historical recovery levels.

We thus believe it could be compelling to overweight the high-yield sector at the expense of investment-grade bonds that offer less probability-weighted upside and seek to take advantage of valuations in distressed credits.

We believe only a very bearish set of circumstances is likely to generate negative returns for emerging markets debt investors over the next year. Our analysis suggests it would likely take a combination of the 10-year U.S. Treasury yield rising and emerging markets debt spreads widening substantially for the asset class to generate a negative return.

This is unlikely, in our view, as spreads have tended to widen more than 200 basis points on global recession fears (and they have widened nearly 150 basis points since last year). If fears about a global recession do materialize, we expect to see a significant drop — rather than a rise — in the 10-year U.S. Treasury yield, which would likely act as a cushion against spread widening. Our base case is that the U.S. 10-year U.S. Treasury yield stabilizes at around 3% and spreads tighten back to more historical levels. In this case, the asset class could generate compelling returns for emerging markets debt investors over the coming year.

And long-term, we believe low historical default rates and high recovery values bode well, offering emerging markets debt hard currency investors attractive return potential. Thus, we now believe that emerging markets debt may represent a buying opportunity for investors looking to take advantage of higher yields and improved valuations. The main reasons are strong interest in retaining market access and strong support from multilateral organizations.

Of course, in today's environment, nothing is certain. We remain focused on navigating risks and changing market conditions to identify attractive investment opportunities.

This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.