August 1, 2023 | Emerging Markets Debt
Head of the Emerging Markets Debt Team, Portfolio Manager
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Emerging markets (EM) debt, U.S. high-yield debt, and leveraged loans typically appeal to the same investors. And while all three are widely considered “high-risk” asset classes, they’re risky for different reasons—and those reasons may give EM debt the edge today. It all comes down to defaults, duration, and the U.S. dollar.
The global macro environment continues to improve, with U.S. economic resilience offsetting some of the disappointment surrounding Chinese growth (which has failed to expand as fast as expectations). The global disinflationary process continues and the peak in policy rates is in sight. But while we believe we are close to the end of the monetary-policy cycle, the peak in the credit cycle will likely occur sometime in the future, in our opinion.
That brings us to our first D: defaults.
In the United States, short-term interest rates have risen from 0 basis points (bps) to more than 500 bps in a very short period—and as interest costs rise, pressuring corporate cash flows, we expect increased defaults. We are close to a large maturity wall for global corporate debt, with about $5.3 trillion of public bonds and institutional loans set to mature by the end of 2025. That’s about 26% of the notional amount in reference indices, according to Morgan Stanley Research. Interest costs are rising across the board, with riskier corporate credits struggling to refinance at current rates (if they can at all).
But it’s not just about rising interest rates. Lenders will likely be more selective in issuing credit because capital ratios are under higher scrutiny, in part due to the regional bank turmoil of late winter/early spring.
Defaults could vary based on region. Although credit quality in U.S. high-yield debt is supposedly higher than it has been in previous years—thanks to more bonds being secured with assets and a greater proportion of higher-quality issuance—U.S. corporates are likely more vulnerable to the rise in rates than EM credit. That’s because EM countries are ahead of the United States in the interest-rate cycle. We’re expecting EM rates to ease first, and believe EMs have likely seen their peak in defaults and credit downgrades.
Which brings us to our next D: duration.
When interest rates are high and expected to fall, bonds with longer durations (those more sensitive to changes in interest rates) could potentially outperform. EM debt is one of the longer-duration segments of the fixed-income market.
Why? Rising rates have contributed to low U.S. dollar prices on existing bonds, and low prices equate to higher yields. Higher yields have resulted in higher carry, which is the income generated by a bond over a certain period. This income contribution to total return may provide a decent cushion against further U.S. Treasury rates rising.
In other words, if the difference between the yields of U.S. Treasury bonds and other bonds increases, the higher yields from the other bonds can help offset or mitigate any negative impact on the investment’s return. Given the yield of the asset class as a starting point, it wouldn’t take much spread tightening to see double-digit returns over the next 12 months, in our opinion.
Then there’s our final D: the dollar.
U.S. dollar valuations reached extremes in 2022 as the dollar hit parity with the euro, but as we approach the end of the rate-hiking cycle, we believe the U.S. dollar should weaken.
As of this writing, we expect one more rate hike in the United States and two in Europe, with the United States subsequently cutting rates earlier and more aggressively than Europe. That would likely lead to a convergence in benchmark rates. As rates become more aligned, with Europe’s rates moving closer to or surpassing those of the United States, the dollar would likely continue its depreciating trajectory.
A weaker dollar has tended to 1) boost EM local currency debt investments directly, as it leads to stronger exchange rates, and 2) boost hard currency debt investments indirectly, as it makes it easier to repay dollar-denominated bonds and leads to an improvement in fundamental credit metrics (such as lower ratios of debt to gross domestic product).
We believe both local and hard currency debt could outperform in a weak dollar environment—but local currency exposure has an edge, potentially providing greater diversification and the ability for investors to capitalize on global opportunities.
With that as the backdrop, why should investors consider EM debt over comparable fixed-income asset classes—namely, U.S. high-yield debt and leveraged loans?
As noted above, EM debt and U.S. high-yield debt are both widely considered risky fixed-income investments, but they have some differences, and those differences may give EM debt an edge in today’s environment.
First, U.S. high-yield debt is definitionally high-yield (below investment grade), while EM debt is split-rated, meaning different rating agencies give different ratings to the same issue. One rating agency may rate a bond BBB-, while another rating agency rates it BB+. Credit quality is higher in EM debt than it is in U.S. high-yield debt, with more than 50% of the EM debt market, as measured by the JP Morgan EMBI Global Diversified Index, being rated investment grade.
Second, duration in EM debt is also almost two times higher than duration in U.S. high-yield debt. Although duration has hurt EM debt over the past two years, now that we are (hopefully) close to the end of the rate-hiking cycle, we believe this headwind could become a tailwind and support EM debt performance.
Third, U.S. high-yield debt default rates have fallen to near zero due to exceptionally accommodative policy from the U.S. Federal Reserve (Fed) and stimulus from the U.S. Treasury. This is one of the factors that has led U.S. high-yield debt to outperform. But we believe defaults are likely to rise as corporations adjust to higher borrowing costs and debt markets become more selective. In addition, if interest rates stay higher for longer than expected (to ensure that we’ve solved the global inflation problem), this will disproportionately hurt U.S. high-yield debt, as corporations will face higher borrowing costs. This is not as true with EM debt, as the asset class is likely past the peak of the default cycle and EM economies are further along in their rate cycle.
The case for EM debt relative to leveraged loans is even more appealing than the case for EM debt relative to U.S. high yield debt.
A leveraged loan is a type of loan typically provided to companies with high debt levels or low credit ratings. These loans often carry higher interest rates due to the increased risk associated with lending to borrowers with weaker financial positions.
Currently, leveraged loan quality is even lower vs. U.S. high-yield debt quality, and it’s been getting worse, with numerous downgrades in recent months. Leveraged loans could also experience more fundamental headwinds than high-yield debt because their coupons adjust with the reference interest rate, which would trend down as rates fall. EM debt, as noted above, has the edge here, being higher rated. While we believe EM debt is past the peak of its default cycle, we expect leveraged loan defaults to increase significantly in 2023 and 2024, in part due to rising fundamental headwinds.
As the rate cycle turns, coupons should adjust downward in loans. EM debt, being exposed to longer duration, should benefit. Leveraged loans are variable-rate products, meaning their coupons adjust with the reference rate on a periodic basis. Thus, they only carry interest-rate risk until their next adjustment. The interest-rate risk in these products is embedded in their fundamentals, as higher interest payments use more of the issuers’ cash flows, constraining other uses and ultimately impacting the borrowers’ ability to repay their debt.
Lastly, many leveraged loan maturities are coming due over the next three years—nearly a quarter of total outstanding debt—and the bulk of them are lower-quality loans. This is happening at a time when banks are incrementally pulling back on extending credit. This maturity wall isn’t as much of an issue in the EM debt market, because the asset class has a longer duration and is past the peak of its default cycle, as noted above.
EM debt, U.S. high-yield debt, and leveraged loans typically appeal to investors searching for additional yield for their portfolio, but given the current underlying drivers, EM debt may be a more timely choice.
Marcelo Assalin, CFA, partner, is the head of William Blair’s emerging markets debt team, on which he also serves as a portfolio manager.
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