Fixed income investors will suffer large mark-to-market losses in 2021. It was even worse for many emerging market debt holders. Emerging market debt has been one of the worst performing asset classes so far this year. investcos
Multiple forces have conspired to cause such widespread pain.
Higher interest rates in the US
US bond yields are partly to blame. In response to rising inflationary pressures, short and long-term interest rates have shot up. US Treasuries serve as a market benchmark, with the yield of other government bonds quoted as a spread to US Treasuries. One of the reasons dollar-denominated emerging market debt is underperforming local currency debt is the sharp rise in Treasury yields.
US 10-year yields more than doubled in 2022, rising from 1.5% to over 3%, causing losses for government, corporate and mortgage holders. The Bloomberg Barclays Aggregate Bond ETF (AGG
Negative impact of US dollar strength
The rise in US yields, coupled with safe-haven flows, has lured foreign investors into US dollar assets. The dollar has appreciated against almost all currencies this year and is trading near multi-decade highs. As a result, many developed and emerging market currencies are hovering near their all-time lows.
While this should be good for export-oriented economies, it also leads to inflation as imported goods become more expensive. A downward spiral in currencies is of particular concern to investors in dollar-denominated bonds issued by emerging markets.
Emerging market central banks have responded to the undue pressure by tightening monetary policy to address the feed-through of weaker currencies to domestic prices. In addition, rapidly weakening currencies and high FX volatility could cause significant dislocations in an economy, undermining financial and political stability.
Economic growth is trending downwards
A slowdown is underway in developed and emerging markets. Recession fears are putting downward pressure on commodity prices, particularly industrial metals such as copper. Many emerging markets remain export-oriented and very sensitive to changes in growth and commodity values.
Even as growth prospects deteriorate, central banks are likely to lengthen interest rate hike cycles and shift monetary policy deeper into contractionary territory. Commodity prices surged following Russia’s invasion of Ukraine, but most have subsequently returned to pre-war levels or fallen even lower on expectations of a slowdown in global demand.
Deteriorating terms of trade due to lower exports for some emerging markets often leads to weakness in the currency market, which helps push up inflation and prompts central banks to respond by raising interest rates. EM assets — both debt and stocks — tend to do better when the global economy is expanding rather than contracting.
Widening global credit spreads
Emerging market bonds not only have an interest rate component, but also a credit component. Unlike AAA-rated U.S. Treasuries, most emerging market debt is rated low investment grade (BBB) or high yield (BB or below).
In a world where capital allocators are shifting from one asset class to another in search of the highest return with the lowest risk, EM bonds will suffer from a widening credit spread environment. A recent Barclays report for institutional investors highlights that valuations relative to maturity and US comparable ratings are still not inviting. They note that EM investment grade bonds are historically rich in US corporate bonds and EM high yield does not look as cheap relative to US counterparts. While EM bonds have been re-rated, so has everything else.
Increased geopolitical risk
There will always be geopolitical risks in the markets. Investors take these risks into account when evaluating financial investments. When investors are surprised by something they didn’t see coming, volatility increases. An example of this is Russia’s invasion of Ukraine. Risks of conflict were piling up, but few analysts and investors thought the conflict would escalate so quickly, leading to a global energy crisis.
International trade maps are being redrawn, and the result will have lasting repercussions for emerging economies and geopolitics. Investors are better at dealing with risk than with uncertainty. Currently, uncertainty about the situation in Russia has created an enormous range of possible outcomes and investors are demanding higher risk premia to account for potential negative and tail outcomes. Emerging market debt, particularly from countries directly affected by war, is extremely vulnerable to such unpredictable forces.
US interest rate market volatility
Implied volatility in the US Treasury market, as measured by the MOVE index, has risen to the highest level since the pandemic-related panic of spring 2020, prompting higher risk premia demands.
Risk aversion, capital outflows, and interest rate and currency volatility have pushed realized volatility in EM local 10-year bond markets (measured on a sample of 13 countries) to nearly twice US Treasury bond volatility in one month, according to Barclays. This level is near the peak of the early stages of the pandemic. Barclays argues that it is volatility in US interest rates rather than the level of US Treasury yields that is driving EM fixed income stress.
The turmoil in the emerging market bond market can be illustrated by taking a closer look at some countries:
Ukraine’s struggles are evident: Russia’s invasion has restricted trade, disrupted daily life and stunted economic growth. The situation is so bad that the country is trying to delay paying foreign debts. Kyiv wants to reach an agreement with bondholders by August 15, which provides for a two-year payment freeze.
Bondholders have dumped their holdings, making Ukraine one of the worst-performing issuers of US dollar government bonds. Ukraine has about $25 billion in outstanding external debt, making it a sizeable emitter. Its dollar-denominated bonds maturing in 2028 are yielding 58% and trading at around 20 cents on the dollar, down more than par before the Russian invasion in February. Despite international support, holders of Ukrainian debt are expected to suffer a significant discount in a restructuring.
Colombia’s bond market has suffered from the election of a left-wing government and its plans to halt new crude oil exploration. Crude oil accounts for more than 30% of the country’s exports. President Petro is also trying to expand welfare programs and impose higher taxes on the rich. Investors have also voted, pushing up the price of local currency and US dollar bonds.
The price of the 7.25% local currency bond maturing in 2050 has fallen from 86.1 at the start of the year to a current price of 57.1, giving bondholders a negative yield of 33%. The 2050 bond is now yielding 13%, up from 8.5% in January. Foreign investors fared even worse. The Colombian peso has lost 6% of its value against the US dollar. A weak currency and inflation approaching 10% prompted the central bank to hike rates by 150 basis points at the end of June.
Colombia’s US dollar-denominated bonds have fallen in price due to the rise in US interest rates and the widening of credit spreads. The BB-rated USD bond with a coupon of 6.125%, maturing in 2041, has fallen to 78 cents on the dollar from a price of 103 in January. The yield on this bond is now 8.5%, up from 5.85%. Holders are sitting on a YTD mark-to-market loss of 21%.
Colombia’s debt is being hit from all sides: a slowdown in growth, political unrest, a strong dollar and a general widening of the credit spread.
Hungary has one of the worst performing local currency bond markets in the world. Fitch named it one of the most vulnerable European countries due to its exposure to Russian gas. The country has low levels of foreign exchange reserves and its current account has expanded. Core inflation rose to an annualized 13.8% in June, prompting the central bank to hike interest rates by 200 basis points to 9.75% earlier this month. An ongoing dispute over the rule of law with the EU is jeopardizing future funding. Depreciation pressure on the forint has resulted in a 15% fall in value against the US dollar. Obviously there is a lot of headwind for Hungary at the moment.
Economic and political uncertainty has driven bond investors to flee. The 3% local currency bond through 2041 has plummeted from 78 cents on the dollar to 51 cents this year. A change in sentiment requires stabilization of the forint and a resolution to the energy crisis plaguing across Europe.
EM government bond investors are licking their wounds and waiting for a turnaround in the external environment that has wreaked havoc on the bond market. As these forces subside, the pressure on EM should also subside.