# Go Hard or Go Home? A Case for (Select) Hard Currency Emerging-Market Debt

### Covid-19 is likely to winnow out the weak from the strong in emerging markets. Those countries with lower external debt burdens and floating FX regimes may be better prepared to weather the coming storm.

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### Introduction: Assessing the Aftermath of the Covid-19 Shock Waves

Regardless of whether you are deep in the trenches of the financial markets, or watching from the sidelines, the year 2020 is an unprecedented time for all of us. The shock waves from the Covid-19 pandemic have rippled across the globe, hitting not just the markets, but also our daily lives. Many of us have had to adjust our routines to incorporate shutdowns across virtually all sectors, and new norms that include face masks and social distancing, home schooling and increased virtual meetings.

Likewise, the market has also needed to adjust to a new reality – one marked by a spike in volatility, wider spreads and a collapse in oil prices. The demand shock has led to new firsts for the market as well, including anomalies such as oil contracts trading at negative prices – an unforeseen repercussion of exchange-traded funds in the space and a lack of storage capacity.

As we digest all these changes happening around us and look forward to the future, it begs the question as to where the opportunities may lie ahead. Emerging-market debt was not immune to the selloff on the back of the Covid-19 pandemic, with both the hard currency segment of the asset class down -4.4% and the local currency segment down -7.5% year-to-date (for the JP Morgan EMBIG index and GBI-EM Global Diversified index, respectively, as of 26 May, 2020). While valuations have improved, this was in tandem with a deterioration in the credit profile and fundamentals for these countries.

Across both developed and emerging markets (‘EM’), governments have moved quickly to cushion the blow to their economies through increased expenditures to support health and income levels. The fiscal outlook for many of these countries is expected to bear the brunt of the burden as it takes a hit from both sides – a collapse in output and revenues, coupled with extraordinary expenditures to avert a further erosion of the fiscal base. While a strong fiscal response is warranted, this comes at a cost, with the debt trajectory for many countries set to accelerate.

While developed markets (‘DM’) generally have credible institutional frameworks and robust financial markets to help buffer against the impact of larger deficits and higher debt burdens, many EM countries are in a more vulnerable position. Borrowing constraints for EM countries are expected to be more challenging, with little cushion to fight an uphill battle of excessive debt amidst rising borrowing costs and slower growth.

While the correction in asset prices was broad-based, we believe the return profiles for EM debt will diverge further going forward – both between hard and local debt, as well as within certain segments of those asset classes. More specifically, we are of the view that select segments of hard currency EM debt may be in a relatively robust position over the medium term, while local markets will be forced to adjust further.

Faced with higher deficits and borrowing needs, EM countries may be forced to depreciate their currency to dilute their domestic debt in real terms, effectively inflating their way out of their debt burden through the depreciation pass-through. Those countries with relatively stronger balance sheets and floating FX regimes should be able to make the necessary adjustments to pay back their external debt, which should prove more advantageous for hard currency over local currency debt, in our view.

That said, we believe the road ahead is expected to be bumpy, necessitating prudence in country selection. Not all hard currency EM debt will be left unscathed, with the most vulnerable countries being those with overvalued real effective exchange rates and pegged or heavily managed FX regimes, particularly those that also rely heavily on commodities/oil.

### All That Glitters Is Not Gold

When assessing opportunities in the EM debt landscape, valuations cannot be looked at in isolation, but must be considered alongside any shifts in the fundamental trajectories of those countries. Looking at valuations, spreads on hard currency EM debt (as measured by the JPM Emerging Market Bond index, or EMBIG) have widened +202 basis points, reaching a z-spread to worst of 487bp as of 26 May, 2020. The investment grade (‘IG’) segment of the market fared better, but still widened +134bp over that period to 304bp (largely offset by the rally in rates, translating to +12bp of an increase in yields).1

Spreads have widened materially, but all that glitters is not gold. Given an expected rise in default rates, we think taking a more granular approach in order to better understand the risk/reward profile for the asset class is prudent. As can be seen in Figure 1, 85bp of the 487bp headline spread of the EMBIG is attributed to countries that comprise 2.5% market value of the index, but that are currently in default or not paying (Argentina, Ecuador, and Lebanon).

Then there is a second group of countries – many of which are oil producers and/or have an overvalued real-effective exchange rate – that comprise 10.9% of the market value of the benchmark and contribute to 92bp of the overall spread, but which we view as high-probability default candidates. The weighted average price for this group of countries was USD92.0 as of 26 May, 2020. Barring a meaningful rebound in oil or growth, we think the prices for these countries need to adjust further to better reflect the credit and default risks.

Finally, the remaining 86.7% of the market value of the EMBIG, comprised of those countries which are neither in default nor at high risk of default in our view, contributes to 303bp of the benchmark spread and has an average spread of 349bp. This is the segment of the market which may be relatively more resilient – particularly for the 10-15 countries which account for the majority of the market value of the EMBIG, have floating FX regimes and more manageable external debt loads. The countries that meet these criteria typically also fall in rating buckets of BB- and above.

##### Figure 1. A Closer Look at the Drivers Behind the JPM EMBIG Spread
Bp Market Value (% of EMBIG) Average Price Countries
Spread contribution of non-default candidates to EMBIG 303 86.7%
Spread contribution from high probability default candidates 92 10.9% 92.0 Angola, Bahrain, Belarus, Belize, Costa Rica, Egypt, El Salvador, Gabon, Georgia, Guatemala, Honduras, Jamaica, Mongolia, Mozambique, Nigeria, Oman, Pakistan, Papua New Guinea, Sri Lanka, Suriname, Tajikistan, Zambia
EMBIG z-spread to worst 487 100.0%

Source: Man GLG, JP Morgan; as of 26 May 2020.

Fiscal deficits and debt burdens are expected to rise across EM. As such, we believe the opportunity lies in those countries that can depreciate their currencies to restore macroeconomic imbalances and dilute the weight of their local debt. On the other hand, those countries with overburdened balance sheets and pegged or heavily managed FX regimes that fail to adjust are likely to default. Countries with large external vulnerabilities that are at higher risk of capital flight may also opt to turn to capital controls – posing another risk for local markets.

While we believe medium-term outlook favours hard currency EM debt relative to local market debt, we want to emphasize that mark-to-market is likely to remain high across the asset class. For example, even among the countries that we view as a low-default probability, funding needs are expected to remain high (at a time when developed market issuance is also accelerating), along with idiosyncratic risks ranging from less predictable policy measures to contingent liabilities around large state-owned enterprises.

Moreover, although the spread on this segment of the asset class (‘non-default candidates’) has widened to 349bp (comprising 86.7% of the EMBIG), an investor that passively invests in the benchmark could easily see this spread wiped out by credit losses from the high-probability default candidates (comprising 10.9% of the EMBIG), in our view. We could easily envision a scenario where prices on the high-probability default candidates drop -46% from USD92.0 on an average to closer to USD50 (as more default risks get priced, with some issuers trading at more distressed levels), resulting in -5.0% of credit losses at the overall EMBIG level and erasing any carry from its better-quality peers (Figures 1-2).

##### Figure 2. Scenario Analysis of the Impact to the EMBIG From Credit Losses Among High-Probability Default Countries
Potential Credit Loss
Assuming high probability default candidates fall to $40 on avg -6.2% Assuming high probability default candidates fall to$50 on avg -5.0%
Assuming high probability default candidates fall to \$60 on avg -3.8%

Source: Man GLG; as of 26 May 2020. For illustrative purposes only.
High probability default candidates comprises 10.6% market value of the JPM EMBIG at an average price of USD85.5.

The risk posed by this smaller segment of the asset class is particularly concerning given that many active managers have dipped further and further down the credit quality spectrum following years of developed market quantitative easing and a grab for yield. Our analysis suggests that many managers have been running material over-weights in many of these less liquid, frontier markets. In the event that another wave of defaults were to materialise and trigger further outflows from passive and active EMD managers, the better-quality segment of the market is also likely to feel some of the blow due to forced liquidations. In our view, this would potentially provide an opportunity to enter at better valuations for the stronger countries with floating FX regimes.

### Beware of Mean Reversion Trades

Years of excess global liquidity and developed markets’ QE drove the market into complacency, with March 2020 serving as a rude awakening for the need for credit differentiation. In a world where debt issuance trends are expected to accelerate on the back of rising deficits, with EM competing alongside DM for capital, weaker-quality countries are likely to run into challenges rolling their debt, particularly when debt sustainability is questionable.

Yet, even amongst the better-quality segment of the market, we caution against a buy-the-dip mentality and mean reversion trades. Again, valuations must be considered in tandem with fundamentals and a changing landscape. For instance, the IG segment of the EMBIG has changed materially over the past few years, as credits have gotten downgraded to high yield (Pemex being the most recent example) and benchmark rebalances led to the addition of new Gulf Cooperation Council (‘GCC’) countries in 2019 (i.e., Saudi Arabia, Qatar, UAE and Kuwait). These four GCC countries alone have gone from zero weight in the benchmark as at the end of 2018 to representing over 25% of the EMBIG IG sub-index by the end of May 2020.

Figure 3 shows 5-year credit default swap (‘CDS’) spreads for Saudi Arabia, which has the largest weight among the GCC countries in the EMBIG. Spreads have widened by 79bp this year (as of 26 May, 2020), but we do not expect a return to the tights seen in 2019, when Saudi Arabia benefited from higher oil prices and its phased-in inclusion into the EMBIG.

##### Figure 3. Saudi Arabia 5-Year CDS Spreads

Source: Man GLG, JP Morgan, Bloomberg, Haver; as of 26 May 2020.

While Saudi Arabia benefits from a relatively strong balance sheet, it is facing a much more challenging macro outlook coupled with an overvalued real-effective exchange rate. Since oil plummeted from its highs of over USD100per barrel in 2014, Saudi Arabia’s FX reserves have been steadily declining, falling from a peak of USD731 billion in August 2014 to USD462 billion as of March 2020 (Figure 4). With Brent at USD36 per barrel, Saudi Arabia’s fiscal deficit is expected to surge to double digits, further draining reserves. The challenges facing Saudi Arabia are expected to plague the GCC region more broadly as well, at a time when positioning is ever more crowded following last year’s index inclusion and record issuance from the region over the past several years.

##### Figure 4. Saudi Arabia FX Reserves

Source: Man GLG, Haver; latest reported data as of 30 March 2020.

### Conclusion: Survival of the Fittest

Picking good credits rather than making blind beta plays will be key, in our view, to navigating through a much more challenging landscape for EM debt. As countries face larger fiscal deficits and increasing debt burdens, they may need to depreciate their currencies to inflate their way out of their local debt, or in the worst case for market participants, impose capital controls, benefitting hard currency EM debt relative to local market debt.

Within the hard currency segment of the asset class, we believe the landscape will be divided between the ‘haves’ (i.e. those countries with lower external debt burdens and floating FX regimes) and the ‘have-nots’ (i.e. those countries that are overburdened with debt and have pegged or managed FX regimes and overvalued real-effective exchange rates). As default rates increase amongst the latter bucket, there is the potential for mark-to-market contagion among the better-quality segment of the asset class. Whilst it’s possible to have a favourable outlook on select hard currency EM debt over the medium term, sagacity in country selection will be critical during the challenging times ahead.

1. Source: Bloomberg.