The riskiest bond trade in emerging markets is mounting a comeback, offering double-digit returns to those brave enough to flirt with default.
(Bloomberg) — The riskiest bond trade in emerging markets is mounting a comeback, offering double-digit returns to those brave enough to flirt with default.
A rebound in distressed government bonds is helping emerging-market dollar debt to its best start since 2019. All but one of the 10 best-performing developing-economy bonds are in distress — from Bitcoin-touting El Salvador to pandemic-era defaulter Zambia, to serial bailout recipient Argentina.
The rally is, in part, due to prices recovering from rock-bottom levels last year when traders were overly pessimistic about recovery expectations. But it’s also a reflection of how investors pivoted toward riskier investments at the start of the year, driving up assets across financial markets.
While the shift in sentiment may turn out to be temporary, for now it’s a welcome change for the small universe of buyers of distressed securities — a high-risk, high-reward trade in bonds that yield at least 10 percentage points above US Treasuries.
“Distressed countries are among those in the asset class with the most upside potential,” said Carl Ross, partner and sovereign credit analyst at Grantham, Mayo, Van Otterloo & Co. in Boston, which counts distressed Tunisian bonds among its top picks in emerging markets.
Enticing Returns
The payouts can be enticing: El Salvador bonds — this year’s best performer — were yielding more than 30% at the start of 2023. Argentina’s dollar bonds due in 2029 currently trade at around 29 cents to the dollar, more than 60% higher than they did last summer.
It was a drastically different scenario a year ago, when nearly two dozen developing countries were trading in distressed territory amid fears of widespread defaults and a global recession. Sri Lanka, sanctions-tangled Russia and Belarus last year tumbled into default, while Ukraine won support to delay payments.
International bonds from Pakistan lost around half of their value in 2022 as investors grew concerned about nonpayment. A Bloomberg gauge of emerging-market sovereign dollar bonds fell 17.4% last year, the worst performance on record.
Risk Repricing
The global economic picture has since improved, with the International Monetary Fund raising its growth forecast and predicting cooling inflation. Credit-default swaps show the risk of default has fallen to its lowest since before Russia’s invasion of Ukraine last February roiled markets worldwide.
The change in sentiment has created an opening for distressed investors, who found value as prices for some defaulted bonds fell below the amount investors expect to receive in a debt restructuring.
Money managers had invested $4 billion in exchange-traded funds that track emerging markets this year, a large chunk of the $8.7 billion that’s flowed into the asset class, according to JPMorgan Chase & Co. The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) had a $490 million outflow last week, the first withdrawal in five weeks.
So far, emerging-market, government dollar bonds have returned roughly 2.7%, the best start since 2019. That’s largely driven by the rally in the lowest-rated debt, which is up almost 11%, according to data compiled by Bloomberg.
Warning Signs
The bullish outlook from distressed investors runs contrary to some recent calls on emerging markets. Citigroup Inc. strategists advised investors to cut their exposure until there’s clarity on how high the Federal Reserve will raise interest rates, saying the weaker-dollar consensus might prove wrong.
JPMorgan Chase & Co. analysts said sovereign debt is “likely overbought and expensive.” And Man Group Plc., the world’s biggest publicly traded hedge fund, is betting on a rout.
Ecuador last week demonstrated how quickly risky trades can go south. Its bonds plunged after President Guillermo Lasso’s proposed constitutional changes were unexpectedly rejected by voters. Up until that point, the country was among the best performers in emerging markets. Now it’s the worst.
But investors who have stuck with the trade see the strong start of 2023 continuing, helping them beat market returns.
Picking Winners
There are various reasons for optimism: El Salvador, which bondholders feared would default, made good on an $800 million bond that came due last month. Ghana included its local bonds in negotiations with creditors, which should help make its debt load more manageable after a restructuring. And investors are increasingly confident a change in government is in the offing for Argentina.
It also helps that the crises inflicted by Covid and Russia’s war in Ukraine weeded out some of the weakest credits, making it easier to choose winners.
“We have a better idea of which countries have the ability to cope, therefore assessing risk reward and value is easier now than in 2022 or 2021,” said Carmen Altenkirch, a London-based analyst at Aviva Investors. “The market is functioning better over the past few months in part due to a greater degree of certainty.”
–With assistance from Scott Squires, Daniel Hogan, Irene García Pérez and Luca Casiraghi.
(Updates ETF flows in 11th paragraph, returns in 12th)
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