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December 2020
Still positive on EM High Yield bonds
As we move into 2021, central banks across major developed markets have signalled their determination to keep policy rates at near-zero levels for years to support the post-pandemic recovery. With interest rates pinned at ultra-low levels, we see limited capacity for nominal government bonds to offer a buffer against sharp drawdowns in risk assets within portfolios. Investors will need to seek alternative ways to increase portfolio resilience, including an allocation to emerging market high-yield bonds.
Epic November for global corporate bonds
EM HY spreads tightened a staggering 70 basis points (bps) in November. The Total Return of 2.9% makes it one of the top ten performing months for EM HY corporate bonds dating back to 2010. Meanwhile, EM IG spreads tightened an impressive 18 bps. In Developed Markets, US HY spreads tightened an incredible 100 bps for a 3.8% return while US IG tightened 22 bps.
Positive on EM corporate bonds
The outlook for Emerging Market (EM) corporate bonds is currently the most promising it has been in some time. Growth is accelerating and we appear to have an effective vaccine. The US Dollar is weakening, and bellwether commodities such as copper are strengthening. Both are traditionally positive for EM corporate bonds. Under President-elect Joe Biden, US foreign policy should be more multi-lateral and policy based, which should also be salutary for the asset class. Furthermore, even under a divided US Congress, we should see a sizable fiscal stimulus bill which should stimulate economic growth and provide an impetus for risk asset deployment. We are overweight on EM High Yield (HY) bonds and are neutral on EM Investment Grade (IG) bonds.
Robust inflows into EM corporate bonds
Inflows into the asset class have been consistently strong over the past three months. Total outflows year-to-date (YTD) are now only US$-3.85 billion versus more than US$-20 billion a month ago. Local currency bonds still have outflows of US$-6.2 billion YTD but hard currency inflows are a robust US$5.85 billion YTD.
EM default rates are not high
While we may have endured the worst recession in almost a century, this is certainly not reflected in EM default rates. Currently, JPMorgan is expecting a year-end 2020 default rate of 3.5% for Emerging Market Credit, which is roughly at the long-run average. They are projecting a further decline to 2.8% in 2021. Distressed ratios, which are a fairly accurate predictor of future default rates are at pre-Covid-19 levels.
Prefer Asia
We are maintaining our preference for Asia in HY. Asia enjoys a yield advantage compared to countries such as Brazil or Russia, which have much lower yields. We believe that the recent trend in onshore Chinese defaults merit monitoring, but do not view them as systemic threats to the offshore market. Furthermore, as discussed above, we view a Biden presidency as more traditional and diplomacy-based than his predecessor, which should result in lower risk premia for Chinese corporate bonds.
Maintain overweight rating on EM HY and neutral EM IG
We are maintaining our overweight stance on EM HY and neutral stance on EM IG. In a “risk-on” environment, HY should be well-placed to benefit. Furthermore, its valuations both on a historical basis and relative to US HY appear attractive. Finally, its higher credit component should provide more of a cushion against what we believe will be rising rates in the ensuing months.
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