Emerging market bond markets are under pressure. Concerns about whether Russia will make its interest payments this month are leading investors to wonder which other countries are at risk of default.
Billions of dollars of Russian government and corporate bonds are at risk, with as much as two-thirds of the country’s foreign exchange reserves frozen. Russia must make at least $400 million in interest payments over the next ten weeks. Next month, a redemption of no less than $2 billion awaits, according to Bloomberg data.
Uncertainty surrounds Russian credit default swaps - derivative contracts that provide insurance against the default of debts - because the market for these contracts is increasingly dysfunctional. Some traders fear that these swaps, whose estimates of the net outstanding value vary from $6 billion (JPMorgan) to $50 billion (Amundi), will not even pay out in the event of default.
The “Russia risk” also puts additional pressure on other vulnerable economies. Earlier this month, JPMorgan liquidated an Emerging Markets Debt Fund worth $454 million. The cost of credit default swaps, or CDS, for emerging market countries rose to the highest level since March 2020.
The rate hikes flagged by the Federal Reserve and rising commodity prices also are disrupting emerging markets.
Commodities and monetary policy
For commodity importers such as India, rising commodity prices are a negative shock that is likely to take revenue out of the economy and generate inflation, leading to a slowdown in activity, said Ben Robins, Emerging Markets debt specialist at T. Rowe Price.
“For commodity exporters, such as Brazil, rising commodity prices are a positive shock, likely to spur economic activity,” he said. Inflationary pressures, according to Robins, could lead emerging market central banks to make more interest rate hikes and keep rates higher for longer.
Rate hikes, especially by the US Fed, are usually a pain for emerging markets as well. Rate hikes slow down capital flows to emerging markets and make borrowing more expensive, which tends to weaken the currencies and economic growth of the countries.
So far, the more hawkish Western monetary policy “has only led to modest re-pricing of local interest rates in emerging markets, as aggressive rate hikes were already priced in to some extent,” Robins said.
Hedging risks
Andrea DiCenso, portfolio manager of the mixed emerging markets strategy at Loomis Sayles, said EMD investors need to be tactical with portfolio adjustments in these circumstances.
Hedging interest rate, currency and credit risks in emerging markets is complicated, but certainly possible. “We are currently using more credit default swaps to hedge the volatility we are going to see in emerging markets,” said DiCenso.
DiCenso’s portfolio has a tilt towards high-yield corporate bonds, with a preference for Latin America, Africa and the Middle East. “We have always been underweight Asia. We see stable inflows into commodity-exporting countries in South America, such as Brazil. Investors seem to prefer those countries to the more volatile Asian bond markets.”
A country like Egypt should be avoided right now, according to DiCenso. A perfect storm is brewing there. The country is an oil and wheat importer, and its tourism industry is largely dependent on Russians. ”Egypt was the darling of emerging market investors for years, but now I would stay away from it as an investor.”
Risk-on
Despite the increased volatility in EMD markets, investors are still willing to take risk in the fixed income segment of specific emerging markets, DiCenso says.
Advised by Loomis’ Russia analysts, DiCenso’s team built a 40 percent hedge - EM CDX hedge - three days before the Russian invasion that fully offset the price declines in Russia exposure a few days later. Drawdowns were limited and Loomis’ models shows a risk-on environment for emerging market bonds for the time being, according to DiCenso.
“The huge revaluation that has taken place within emerging markets, both for sovereign and corporate bonds, makes the spreads attractive at the moment,” DiCenso said.
The conflict in Russia is being ignored in specific local markets, at least in part. This is largely because of the distance of many countries from the conflict zone, and because the central banks of these emerging markets tackled high inflation last year with serious interest rate increases.
Emerging market central banks tend to be quicker, bolder in raising interest rates than developed market central banks.
This article was originally published in Dutch on InvestmentOfficer.nl.