2021 marks the second consecutive year in which emerging markets hard currency debt has lagged the U.S. credit market in the spread tightening since the pandemic peak of March 2020. In our view, most of the underperformance happened in the EM high yield universe and is driven by country-specific factors.
The EMBI High Yield Index yields 330 bps above the U.S. High Yield Index, which is around two standard deviations relative to the last five years’ average. The EM IG space is tighter, as it offers roughly a 60 bps premium to U.S. IG, which is around the historical average.
The widest spreads in sovereign high yielders are often linked to frontier markets with idiosyncratic stories, like the economic implosion in Lebanon, the unwillingness to engage on reforms in Sri Lanka, El Salvador and Argentina, and more recently, Ukraine’s exposure to Russian aggression. In EM corporates, the largest spread-widening happened in China high yield, where the index spread widened to above 2,000 bps in mid-November from 730 bps in September.
Apart from China and the frontier markets, there are opportunities in more “traditional” EM countries. For example, both IG and HY corporate bonds in Brazil, Chile, Colombia, Turkey, Russia and South Africa have spreads at or above two standard deviations compared to the levels of the past 12 months. Yet, these spreads screen as average over longer time frames while, in each country, there are non-negligible chances of deteriorating creditworthiness due to political risks. Turkey is debasing its currency with huge inflationary pressures as a result. Brazil is having elections next year, potentially leading to more fiscally irresponsible policies. Chile has already been through a volatile political change, which does not look like ending soon, while Colombia is set to enter an election year with the far left leading in the polls.
If one were to look for a single near-term driver of EM-to-U.S. credit spreads, China would be the place to focus. Expected below-potential growth in China is arguably a drag for EM more broadly. Valuations, mainly in the IG space, are vulnerable to widening in case of spillover from China.
To conclude, the pockets of value in EM credit are mostly linked to country-specific developments and should be looked at through a prism of fundamental country and credit analysis, while the IG space has more room for widening versus U.S. credit due to China-related risks.