Recent falls in the price of bonds issued by emerging market governments and companies have been faster than at the onset of the global financial crisis of 2008. The moves reflect the degree of uncertainty facing markets.
There are large discrepancies between competing forecasts for global economic growth – or rather, negative growth – in 2020 and in the years ahead, as a result of the virus. There are different forecasts about the direction of the pandemic itself. While we are seeing a slowdown in coronavirus cases in China and South Korea, it is too early to tell if there will be a second wave of infections as people emerge from being in lockdown.
The threat posed by coronavirus to emerging market economies is serious, as of course it is to human lives. Yet investors can overreact and, where assets are oversold, there can be opportunities for long-term investors.
An indiscriminate sell-off
The decline in investor sentiment towards emerging market bonds has been nothing short of dramatic. Falling prices have pushed up bond yields – the prospective annual income from a bond as a proportion of its price – to levels not seen in a decade.
This increase in yields reflects higher expectations that there will be a rise in defaults – governments and companies failing to keep up with their payments to bondholders.
Defaults will undoubtedly rise during 2020 from their current levels, which are near historic lows, particularly in the corporate space. However, the risk that any government and company will default on its debts depends on their particular circumstances.
Some will be badly hit by the economic slowdown and, being in a vulnerable starting position of high debts and negative cashflow, will need to restructure their debts. Others, however, enter this challenging period boasting solid balance sheets, with less debt, putting them in a stronger position to keep up with their payments to bondholders during a tough period.
The effects of cheap oil
Another critical factor for emerging market bond investors as we enter this global economic downturn is the recent collapse in the oil price.
Saudi Arabia’s decision to raise production effectively shattered OPEC – the cartel of oil-producing states – and has contributed to a mismatch between increased supply and falling demand amid lower economic activity and reduced demand for transport. At just under US$30 a barrel, oil is selling for less than half what it was in January 2020.
For oil-exporting emerging markets this is a challenge, of course, and may in some cases compromise their ability to keep up debt repayments. Certain governments, like Russia, have strong fiscal positions going into this, meaning they should be able to cope with lower oil revenues for the time being. Others, like Ecuador for instance, do not. We might expect these governments to look to restructure their debt piles, which would involve losses for their bondholders.
On the other hand, lower crude prices are a boost to the balance of payments for emerging markets that are net importers of oil. Paying less for energy imports should put economies like India’s in a stronger position to weather the global economic slowdown.
At current prices, it looks like investors anticipate that as many as one in three emerging market governments will not keep up with their debt repayments. Notwithstanding the challenges facing the global economy, I think it is highly unlikely this many will default over the coming years.
I believe the downside risk that emerging market investors face, in terms of potential losses they may bear, is reflected in bond prices, by and large, after their recent fall.
Moreover, unlike developed market bonds, with the level of income that emerging market bonds currently offer there is compensation for the risk that investors are taking.
As emerging market bond yields have risen to their highest levels since 2008, the yields on developed market bonds have gone in the other direction – falling further into negative territory in some cases – as investors have sought the sanctuary they are widely perceived to offer. In late March 2020, the difference the yields available on US government bonds and emerging market government bonds is at its widest in a decade.
This extra income yield offers investors a cushion from any further fall in capital values. In my opinion, it also indicates that there are selective long-term opportunities for active investors in emerging market bonds.
Past performance is not a guide to future performance.
The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.
The views expressed in this document should not be taken as a recommendation, advice or forecast.