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Investors are buying up the bonds of some of the world’s poorest nations so fast that the risk premium on them is falling at the fastest pace since June 2005 compared to their investment-grade counterparts, data from JPMorgan Chase & Co shows. And countries that were teetering on the brink of default just a few months ago, such as Pakistan, Ghana and Ukraine, are leading this high-yield rally.
Prior to this month, the most brutal sell-off since the 2008 financial crisis had already led emerging market fund managers to talk about how cheap high-yield bonds were and how their underperformance relative to higher-rated debt was a unsustainable distortion. But bonds continued to be shunned as US yields surge led by the Federal Reserve’s aggressive monetary tightening. It is only now, with the prospect of a slower pace of interest rate hikes, that investors are coming back.
“Cheaper high-yield emerging market bonds look more attractive than investment grade bonds,” said Ben Luk, senior multi-asset strategist at State Street Global Markets. The recent rebound in commodity prices, especially oil, could also “generate more cash flow and reduce the possibility of any near-term sovereign default.”
The extra yield required by investors to own high-yield emerging-market sovereign bonds rather than Treasuries narrowed by 108 basis points in the month to 15, a JPMorgan index showed. The spread on a similar measure for higher rated debt narrowed by just 23 basis points. That caused the gap between them to narrow 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 outperformance of high yield comes as a wave of expected defaults in the wake of the Russian invasion of Ukraine has yet to materialize, with the exception of Sri Lanka. Most other nations continued to service their debts, making some deals with the International Monetary Fund. This has made investors confident enough to return to bonds for their double-digit yields.
While dollar debt yields for Egypt and Nigeria have fallen since late October to about 13% and 12%, respectively, “the risk of distress is still highly priced,” Tellimer analysts wrote in a statement. e-mail. The risk is being mitigated in Nigeria by limited external depreciation in the coming years and in Egypt by the recent IMF deal and currency devaluation, even if their long-term outlook is not favourable, they said.
“The easing risk appetite has opened a window of opportunity for outperformance in some emerging market assets, particularly those that have been undersold more than fundamentals would have warranted,” Stuart Culverhouse and Patrick Curran of Tellimer. “But caution is still warranted in some of the most struggling histories, such as Ghana and El Salvador, or where external financing needs are great and market access is limited, such as Pakistan.”
While capital markets have closed to riskier borrowers this year, some including Serbia, Uzbekistan, Costa Rica and Morocco could return to fundraising if yields fall further, said Guido Chamorro, co-head of debt in emerging markets hard currency at Pictet Asset Management. Turkey sold bonds this month as the risk premium on its dollar debt fell to a one-year low.
However, smaller emerging economies still have a long way to go before achieving debt sustainability, and this could weigh on investors’ minds in 2023.
Credit ratings have declined in recent years as debt has increased and fiscal reserves have dwindled due to the pandemic and the Russian invasion of Ukraine. In Africa, the Middle East, Latin America and the Caribbean, more than 50% of sovereign bonds are currently rated B or lower, according to Moody’s Investors Service.
According to the ratings firm, this has increased the risk of default or restructuring among sovereign countries with high financing needs over the next three years or large impending debt maturities relative to foreign exchange reserves. The group includes nations such as Ghana, Pakistan, Tunisia, Nigeria, Ethiopia and Kenya.
However, investor panic that drove the gap between risk premiums on high yield and investment grade debt to a record 890 basis points in July has eased amid a flurry of deals with the IMF, pledges financing plans and hopes for a less aggressive federal government. Reserve.
A Bloomberg gauge of high-yield bonds in developing countries has risen about 7% since September, following five quarters of declines in its longest losing streak on record. Average yields have fallen below 12%, after exceeding 13% in October. That has prompted Pictet Asset Management to get “more constructive lately” on the asset class, Chamorro said.
“There are very attractive returns, especially if you can look through periods of short-term volatility that we think will still occur from time to time,” Chamorro said.
What to watch this week:
Turkey’s central bank likely to lower its key interest rate on Thursday for the fourth time in a row to 9%
Israel set to raise its key rate on Monday, extending the longest round of monetary tightening in decades to keep inflation in check
Policy makers in Nigeria, Kenya and Zambia will also set interest rates
South Africa’s inflation data will be closely monitored for clues on the outlook for monetary policy
Thailand and Peru will report on gross domestic product
–With the assistance of Srinivasan Sivabalan.
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