Capital Ideas^TM

Emerging markets (EM) hard and local currency denominated sovereign bonds rose in the fourth quarter of 2022, as a softer-than-expected inflation print in the US and the potential end to China’s zero-COVID policy lured yield seeking investors.

High yield US dollar denominated sovereign bonds gained the most with spreads narrowing 175 basis points (bps). Issuers across sub-Saharan Africa were the main contributors to the rally, despite growing concerns from credit rating agencies that external debt loads are veering toward unsustainable levels for several countries in the region.
Many investors believe the growing risk of potential debt defaults and/or restructuring for these countries is largely priced into current valuations.

Local EM bonds posted strong and geographically diverse returns in the fourth quarter. A key contributor was the weakening US dollar against a broad basket of EM currencies. Throughout most of 2022, EM local bonds were under pressure due to the strength of the US dollar. However, relative to the euro and the British pound, EM currencies held up fairly well. We think any downside catalysts for the US dollar, such as a pause in Fed rate hikes or outright rate cuts, could benefit EM currencies in US dollar terms. These potentially favourable currency dynamics combined with attractive nominal and real yields, particularly across parts of Latin America, lead us to favour a slight tilt toward local currency denominated bonds.

Although high yield dollar denominated spreads narrowed, there are select carry opportunities in both distressed and quasi-distressed credits, where many of the difficulties have already been priced in, as well as some potentially safer high yield credits, such as Egypt, that have access to external funding.

There is value in owning some EM corporate bonds for their geographic diversification benefits and attractive spread pick-up compared to developed market bonds of equivalent duration and rating.

Overall, a combination of cheap valuations and attractive yields across much of the asset class alongside decent policy management in some of the larger local currency issuers, could provide a favourable backdrop for EM bonds in 2023. That said, ongoing geopolitical and economic uncertainties suggest a more cautious and diversified approach to investing is prudent.