Investors are buying the bonds of some of the world’s poorest nations so fast that the risk premium on them is falling at the quickest pace since June 2005 relative to their investment-grade peers, JPMorgan Chase & Co data show. And countries that were tottering on the brink of default just months ago – such as Pakistan, Ghana and Ukraine – are leading this high-yield rally.
Before this month, the most brutal selloff since the 2008 financial crisis already had emerging-market money managers talking about how cheap high-yield bonds were and how their underperformance against higher-rated debt was an unsustainable distortion. But the bonds continued to be shunned because of a surge in US yields driven by the Federal Reserve’s aggressive monetary tightening. It’s only now, with the prospect for a slower pace of interest-rate hikes, that investors are returning.
“Cheaper high-yield emerging-market bonds do look more attractive relative to investment grade,” said Ben Luk, a senior multi-asset strategist at State Street Global Markets. The recent rebound in commodity prices, especially oil, could also “generate greater cash flow and lower the chance of any sovereign default in the near term.”
The extra yield investors demand to own high-yield sovereign bonds in emerging markets rather than Treasuries narrowed 108 basis points in the month through the 15th, a JPMorgan index showed. The spread on similar gauge for higher-rated debt narrowed only 23 basis points. That led to the gap between them shrinking by 85 basis points, the biggest monthly drop since the Fed raised rates eight times by a total of 200 basis points in 2005.
The high-yield outperformance comes as a wave of defaults predicted in the wake of Russia’s invasion of Ukraine has yet to materialize, with the exception of Sri Lanka. Most other nations have continued to service their debts, with some clinching deals with the International Monetary Fund. That’s made investors confident enough to return to the bonds for their double-digit returns.
While the dollar-debt yields for Egypt and Nigeria have fallen since late October to about 13% and 12%, respectively, the “risk of distress is still being heavily priced in,” analysts at Tellimer wrote in an email. The risk is mitigated in Nigeria by limited external amortizations in the coming years and in Egypt by the recent IMF deal and currency devaluation, even though their longer-term outlook isn’t favorable, they said.
“The easing in risk sentiment has opened up a window of opportunity for outperformance in selected emerging-market assets, particularly those that sold off by more than fundamentals would warrant,” Tellimer’s Stuart Culverhouse and Patrick Curran wrote in an email. “But some caution is still warranted in some of the more distressed stories, such as Ghana and El Salvador, or where external financing needs are large and market access is constrained, such as Pakistan.”
While capital markets shut on the face of riskier borrowers this year, some including Serbia, Uzbekistan, Costa Rica and Morocco may return to raise funds if yields decline further, said Guido Chamorro, the co-head of emerging-market hard-currency debt at Pictet Asset Management. Turkey sold bonds this month as the risk premium on the its dollar debt fell to a one-year low.
Still, smaller emerging economies have a long way to go before achieving debt sustainability, and that could weigh on investors’ mind in 2023.
Credit ratings have fallen in recent years as debt surged and fiscal buffers shrank amid the pandemic and Russia’s invasion of Ukraine. In Africa, the Middle East, Latin America and the Caribbean, more than 50% of sovereigns are currently rated B or lower, according to Moody’s Investors Service.
That boosted the risk of default or restructuring among sovereigns with elevated funding needs in the next three years or large upcoming debt maturities relative to foreign-exchange reserves, according to the ratings company. The group includes nations like Ghana, Pakistan, Tunisia, Nigeria, Ethiopia and Kenya.
Yet, investor panic that sent the gap between the risk premiums on high-yield and investment-grade debt surging to a record 890 basis points in July, has eased amid a flurry of IMF deals, bilateral funding commitments and hopes for a less hawkish Federal Reserve.
A Bloomberg gauge of high-yield bonds in the developing world has advanced about 7% since September, after five quarters of declines that was its longest losing streak on record. Average yields have fallen below 12%, after exceeding 13% in October. That prompted Pictet Asset Management to turn “more constructive lately” on the asset class, said Chamorro.
“There are very attractive yields, especially if one can look through short-term volatility periods that we think will still happen from time to time,” Chamorro said.
What to watch this week
While South Africa is widely expected to raise the key rate on Thursday, economists and traders can’t agree on the quantum against the backdrop of slowing inflation in an economy flirting with recession.
The median of 20 economists’ estimates in a Bloomberg survey is for a hike of three-quarters of a percentage point, with projections for an increase ranging from between 50 to 100 basis points.
Inflation data from South Africa will be closely watched for clues on the outlook for monetary policy.
- Turkey’s central bank will likely lower its benchmark interest rate on Thursday for the fourth time in a row, taking it to 9%. With the world’s worst real rate, the Turkish lira is one of the worst performers in emerging markets this year despite central-bank interventions.
- Israel is set to raise its benchmark rate on Monday, extending its longest cycle of monetary tightening in decades to keep inflation in check.
- Policy makers in Nigeria, Kenya and Zambia will also set interest rates.
- Thailand and Peru will report on gross domestic product.
© 2022 Bloomberg L.P.