- Our constructive outlook for emerging markets (EM) implies strengthening fundamentals for EM hard currency issuers. Supported by our bearish USD view, this suggests improving ability to service sovereign USD debt and lower refinancing risks.
- While fiscal risk and macro vulnerabilities do exists for EM issuers, our findings show that risk should be relatively low and manageable moving forward. EM credit default swap index and sovereign credit ratings, are also pointing to a declining default probability as well as a moderating ratings downgrade trend.
- EM hard currency debt still provides attractive yield pickup over both investment grade and high-yield peers. We also see further scope for spread tightening and spread suggests a decent annualised return of 6.4% over the next 2 years.
- The main challenge will likely come from EM hard currency debt’s stiff valuation and relatively higher duration risk. As such, have dialed back our initial optimism, but hold a cautiously optimistic view on the asset’s outlook. We believe EM hard currency may still offer tactical upside from further spread tightening and yield pickup.
Chart 1: Country exposure for EM hard currency debt
Robust macro outlook lowers credit risk
Chart 2: EM GDP growth forecasted to rebound above 10-year average
Fiscal risk and out-of-control external debt?
- Most issuers possess an external debt ratio that is around the global EM average, which is also less than DM average (chart 3.1).
- About 35% of the issuers have higher FOREX reserves than external debt, generally indicative of less macro vulnerabilities (chart 3.1).
- Those 'higher risk' with FOREX reserves less than external debt – Bahrain, Chile, Egypt and Ukraine – comprised only 11% of the EM hard currency universe. Even so, the outlook of Bahrain, Egypt and Ukraine were rated stable by all 3 credit rating agencies (Moody’s, Fitch, S&P) (chart 3.1).
- Budget deficit (% of GDP) is projected to decline across most issuers this year, a sign of improving public finances (chart 3.2).
Chart 3.1: Assessing riskiness via external debt and foreign exchange reserves
Chart 3.2: Assessing riskiness via budget deficit forecast
Chart 4: Credit default swap index for EM back to pre-Covid level and implying low probability of default
Chart 5: Trend in sovereign credit rating downgrades is fading
Decent yield pickup vs IG and HY sectors
Chart 6: Decent yield pickup from EM hard currency debt
Decent long-term return prospects
Chart 7: Return potential for spread of 300 - 400 bps still higher than 10-year annualized return
Key challenges moving forward – Stiff valuation and interest rate risk
Chart 8: Spread is below historical average (Z-score of -0.3) – valuation increasingly expensive
Cautiously optimistic view moving ahead
Table 1: Recommended products
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Unit Trust |
ETF |
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EM Hard Currency |
Neuberger Berman Emerging Market Debt Hard Currency A MDis SGD-H |
The Research Team is part of iFAST Financial Pte Ltd.
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