The emerging market (EM) debt rally kept rolling in the second quarter although gains moderated somewhat from the strength shown in the first quarter. The rally appears to be driven more by technicals than fundamentals, as investors searching for yield continued to pile into the sector.
Local-currency sovereign debt had a total return of 3.6%, powered mostly by the strength of the euro against the dollar and the “carry” – profit earned by borrowing at a low interest rate and investing in an asset that provides a higher rate of return (see exhibit below). External dollar-denominated sovereign debt advanced 2.2%, thanks to spread compression versus U.S. Treasurys, as well as the rally in Treasuries themselves. The same factors also helped corporate dollar-denominated debt gain 2.0%, and they also benefitted from spread compression versus sovereign debt.
A clear sign of the rally’s technical strength can be seen in the negative events of the quarter that investors managed to shrug off. These include renewed political tensions in Brazil, the regional embargo on Qatar, the deterioration in U.S./Russia relations, and the drop in oil prices. At the same time, a number of transactions took place in the second quarter that we would view as signs of a market top. Leading the list would be Argentina’s recent sale of 100-year bonds. In today’s yield-starved environment, the deal was three-times oversubscribed with a yield of 7.9%. Other signs, in our view, would be offerings from Maldives and Nigeria’s diaspora bond.
The valuations of EM corporate credit – a sector of the market that has experienced explosive growth over the past few years – look particularly stretched to us. While the potential for EM corporate credit is significant, in recent years we have seen fundamentals deteriorate.
Profitability has waned, as leverage has grown and interest-coverage ratios have fallen below U.S. corporate levels, leading to an increase in refinancing risk. Despite these warning signs, corporate spreads over sovereigns have tightened from 270 basis points (bps) in February 2016 to 115 bps as of June 30, 2017, based on Eaton Vance proprietary data and calculations for bonds in the JPMorgan Corporate Emerging Markets Bond Index (CEMBI). Overall, we do not believe investors are receiving enough incremental yield above sovereign spreads to compensate for the extra credit and liquidity risks.
However, the rapid growth of the asset class means that the EM corporate debt universe should continue to offer pockets of value and opportunities, for several reasons:
- The analyst community remains focused on larger, liquid issuers in the CEMBI, leaving many companies that are smaller and/or not as well understood.
- Spreads, credit fundamentals and technical factors vary by region. For example, Latin America, Eastern Europe and African companies offer far more spread than Asian and Middle Eastern credits.
- Secular tailwinds exist as economic growth in EM remains meaningfully above developed market countries.
The EM FX outlook remains challenging as it is the most exposed to the three big uncertainties—China, oil and the Fed. The scope for further gains through sovereign credit spread tightening is limited, while fundamentals in EM countries are becoming more of a concern, particularly in Africa.
With interest rate differentials between EM and developed markets near their widest in 10 years, EM rates remain the most attractive risk factor despite the potential for global yields to move higher.
After a strong first half of 2017, finding value in EM debt will require careful fundamental analysis as the risk of a broad selloff is growing.
Michael Cirami is Eaton Vance’s vice president and co-director of Global Income