A man is seen in front of a screen showing the exchange rate between the Colombian peso and the United States … [+]
Fixed income investors are taking heavy losses relative to the market in 2021. For many holders of emerging market debt securities, the situation has been even worse. Emerging debt has been one of the worst performing asset classes so far this year. Invesco
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Several forces have conspired to cause such widespread pain.
Higher interest rates in the United States
US bond yields are partly to blame. Short-term and long-term interest rates soared in response to mounting inflationary pressures. US Treasuries serve as a benchmark in the market, with the yield on bonds of other sovereign issuers being quoted as a spread over US government bonds. One of the reasons dollar-denominated emerging market debt has underperformed local currency debt is the sharp drop in Treasury yields.
US 10-year yields more than doubled in 2022, from 1.5% to over 3%, leading to losses for holders of government, corporate and mortgage securities. The Bloomberg Barclays Aggregate Bond ETF (AGG
AGG
Negative impact of the strength of the US dollar
Rising US yields, along with safe-haven inflows, have attracted foreign investors to US dollar assets. The dollar has strengthened against almost every currency this year and is trading near a multi-decade high. As a result, currencies in many developed and emerging markets are hovering near all-time lows.
While this should be good for export-oriented economies, it also leads to inflation as imported goods become more expensive. A downward currency spiral is a particular concern for investors in dollar bonds issued by emerging markets.
Central banks in emerging markets reacted to the excessive pressure by tightening monetary policy to deal with the knock-on to domestic prices of weaker currencies. In addition, rapidly weakening currencies and high currency volatility could generate significant disruptions in an economy and undermine financial and political stability.
Economic growth is down
A slowdown is underway in developed and emerging economies. Recession fears are putting downward pressure on commodity prices, especially industrial metals like copper. Many emerging market economies are still export-oriented and highly sensitive to changes in growth and commodity values.
Even though the outlook for growth has deteriorated, central banks are expected to prolong rate hike cycles, pushing monetary policy deeper into contractionary territory. Commodity prices soared after Russia invaded Ukraine, but most then either returned to pre-war levels or fell even lower on expectations of a slowdown in the economy. global demand.
Deteriorating terms of trade due to lower exports from some emerging economies often leads to weak foreign exchange markets, which contributes to higher inflation, prompting central banks to respond by raising interest rates . Emerging market assets – both debt and equities – generally do best when the global economy is expanding, not contracting.
Widening global credit spreads
There is not only an interest rate component in emerging market debt, but also a credit component. Unlike U.S. government bonds which are rated AAA, most emerging market debt is rated lower-investment grade (BBB) or high-yield (BB or lower).
In a world where capital allocators shift from one asset class to another in search of the best return for the least risk, emerging market bonds will suffer in an environment of widening credit spreads. A recent report from Barclays for institutional investors highlights that valuations relative to maturity and US rated peers are still not attractive. They note that in historical terms, emerging market investment grade bonds are rich relative to US corporate bonds, and that emerging market high yield debt is not as cheap as its US counterparts. As emerging market bonds have been repriced, so has everything else.
High geopolitical risk
There will always be geopolitical risks in the markets. Investors take these risks into account when valuing financial assets. It’s when investors are surprised by something they didn’t see coming that volatility spikes. An example of this is Russia’s invasion of Ukraine. Risks of conflict were mounting, but few analysts and investors believed the conflict would escalate so quickly and to the point of causing a global energy crisis.
The maps of international trade are being redrawn and the result will have a lasting effect on the economy of emerging countries and on geopolitics. Investors are better at managing risk than uncertainty. Currently, the uncertainty surrounding the situation in Russia has created a wide range of possible outcomes, and investors are demanding a higher risk premium to account for potential negative and “extreme” outcomes. Emerging market debt, especially that of countries directly affected by war, is extremely vulnerable to these unpredictable forces.
US Interest Rate Market Volatility
Implied volatility in the US Treasury market, as measured by the MOVE index, hit its highest level since the pandemic-induced panic in the spring of 2020. The record level of implied and realized volatility spread to bond markets emerging markets, forcing investors to demand higher risk premia.
Risk aversion, capital outflows, and interest rate and currency volatility drove up one-month realized volatility in emerging markets 10-year local debt markets (as measured by a sample of 13 countries ) at just under twice that of US Treasury volatility, according to Barclays. This level is near the peak of the early stages of the pandemic. Barclays says it is the change in US rates rather than the level of US Treasury yields that is causing stress in emerging market fixed income.
The turmoil in the emerging market debt market can be highlighted by looking at a few countries in more detail:
Ukraine
Ukraine’s struggles are obvious: Russia’s invasion has restricted trade, disrupted daily life and shattered economic growth. The situation is so serious that the country is seeking to delay payments on the external debt. Kyiv wants to reach an agreement with bondholders by August 15 that involves a two-year payment freeze.
Bondholders sold their holdings, making Ukraine one of the worst-performing issuers of US dollar sovereign debt. Ukraine has about $25 billion in outstanding external debt, so it’s a significant issuer. Its dollar bonds due 2028 are yielding 58% and trading around 20 cents on the dollar, down from parity before Russia’s invasion in February. Despite international support, holders of Ukrainian debt are likely to suffer a significant discount during a restructuring.
Colombia
The Colombian bond market suffered from the election of a leftist government and its plans to eliminate all new exploration for crude oil. Crude oil represents more than 30% of the country’s exports. President Petro is also seeking to expand social programs and impose higher taxes on the wealthy. Investors also voted, sending bond prices plummeting in local currency and US dollars.
The price of the 7.25% local currency bond maturing in 2050 has fallen from 86.1 at the start of the year to a current price of 57.1, leaving bondholders with a negative yield by 33%. The 2050 bond now yields 13%, down from 8.5% in January. Foreign investors have done even worse. The Colombian peso lost 6% of its value against the US dollar. A weak currency and inflation approaching 10% prompted the central bank to raise interest rates by 150 basis points at the end of June.
Colombian bonds denominated in US dollars fell in price due to rising US interest rates and widening credit spreads. The 6.125% coupon bond, rated BB, maturing in 2041, fell to 78 cents on the dollar, from a price of 103% in January. The yield on this bond is now 8.5%, down from 5.85%. Holders are sitting on a 21% loss to the market year-to-date.
Colombian debt is being hit from all angles: a slowdown in growth, political unrest, a strong dollar and a general widening of the credit risk premium.
Hungary
Hungary has one of the worst performing local currency bond markets in the world. Fitch called it one of the most vulnerable European countries due to its exposure to Russian gas. The country has a low level of foreign exchange reserves and its current account has expanded. Core inflation reached an annualized rate of 13.8% in June, prompting the central bank to raise interest rates by 200 basis points to 9.75% at the start of the month. An ongoing dispute with the EU over rule of law issues threatens future funding. The pressure to depreciate the forint led to a 15% loss in value against the US dollar. Obviously, there are a lot of headwinds for Hungary at the moment.
Economic and political uncertainty scared away bond investors. The 3% 2041 bond in local currency has collapsed from 78 cents on the dollar to 51 cents this year. A turnaround requires a stabilization of the forint and a resolution of the energy crisis raging across Europe.
Investors in emerging market sovereign debt are licking their wounds, waiting for a turnaround in the external environment that has devastated the bond market. When these forces subside, the pressures on EM should also decrease.
