27 Aug COTW: Emerging Markets, Developed Risks
The chart below can be downloaded here.
After a decade of outperformance relative to U.S. core bonds, emerging market bonds (as proxied by the J.P. Morgan Emerging Market Bond Index) have struggled recently (-5% YTD through Friday) as concerns about the ability of several countries to repay their external debt obligations have become more acute. The issues are not new, but have been brought into the limelight recently as tightening U.S. financial conditions and a rising U.S. dollar have increased the servicing costs on these foreign debts. The areas of greatest concern are countries like Turkey, Argentina and South Africa due to their persistently large current account deficits (reliance on foreign inflows) and significant external debts (high accumulated debt balances), most of which are denominated in foreign currencies.
The intersection of these two factors is presented in the chart below with the size of the bubbles referencing the weight of each country in the J.P. Morgan Emerging Market Bond Index. Turkey, for instance, has an external debt-to-GDP ratio of over 50%, a current account deficit of over 7% and represents 3.7% of the index. The three problem countries listed above represent about 10% of the index.
We view emerging market bonds through the same lens as any other spread bond category: higher risk (i.e. the risk of a default) is fine as long as we believe the yield compensates us for that risk. The current yield on emerging market bonds is a little over 5% while sovereign default rates have averaged about 1.3% for the last 20 years; however, that number may be misleading given the massive increase in the size of the asset class and the easy availability of capital as global investors reached for yield. Assuming defaults stabilize at 2%, emerging market bonds are priced to outperform investment grade U.S. bonds by about 100 bps for the next decade. By our estimates, the break-even default rate where the returns of emerging market bonds will be less than U.S. investment grade bonds is 3.2%. Given the problem countries below represent about 10% of the index, we would like to see yields even higher before allocating capital to emerging market bonds.
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