December 17, 2020 | Vanguard Perspective
Economic fundamentals differ vastly among emerging-market sovereign debt issuers. That has greatly influenced the extent to which emerging nations have been able to finance the domestic support extended during the COVID-19 epidemic. Asset managers’ evaluation and anticipation of such differences in credit fundamentals are critical for investment decisions even during normal years, but especially so in today’s rapidly evolving fiscal environment.
While recent vaccine breakthroughs are positive news for health outcomes and global growth, how successful emerging market countries are in implementing national vaccination programs will further contribute to diverging fundamental outlooks.
Vanguard's emerging markets credit team continually assesses issuers' fundamentals and debt loads and, more important for investors, where they may be headed.
"We still believe there will be attractive opportunities to seize in this asset class," said Micah James, one of Vanguard's emerging markets credit analysts based in the United States, “but deep fundamental analysis and active management will be even more critical in identifying them."
Credit quality varies greatly among emerging markets. Vanguard's "one team" approach helps ensure that the best risk-adjusted trades are made based on the distribution of possible outcomes. "We don’t shy away from low-quality or distressed opportunities—doing so would put us at risk of underperforming the market," said Mr. James. "Rather, we work to ensure that we are in the best risk-adjusted trades in each quality bracket based on our fundamental outlook and what is priced into the market."
"Countries we classify as 'high quality' based on our internal criteria began 2020 with sound solvency metrics and high levels of institutional credibility," said Nick Eisinger, a U.K.-based emerging markets credit analyst. "As a result, they retained significant flexibility in funding their crisis response efforts."
Chile and Poland stand out for extending very large support packages—including direct spending on health care and social safety net programs in addition to stimulus stemming from tax breaks. Data presented in the IMF’s October Fiscal Monitor shows that those support packages ranged from 6 to 8 percentage points of GDP, which are much closer to the 9% average for advanced economies than the 3% average for emerging economies.
In addition to accessing external debt markets at historically low yields, Chile and Poland have been able to tap their particularly well-developed local debt markets because of the high levels of institutional credibility their central banks have built up following years of successful inflation targeting. They were also among a number of high-quality countries able to implement quantitative easing through central bank purchases of government debt.
"High-quality countries will run larger fiscal deficits on average," noted Nishan Pradhan, an emerging markets credit analyst based in Hong Kong, "but will be better positioned for a growth rebound than lower-quality countries will because the economic scarring associated with deep recessions should not be as prevalent." They will be able to carry out additional domestic relief with ample financing flexibility and market access. Debt stocks will increase, but affordability metrics should remain favorable.
"Even within this high-quality bracket, though, rising debt-to-GDP levels need to be monitored as they may breach certain ratings thresholds," cautioned Mr. Pradhan. "In Asia, for example, Malaysia and India run the risk of rating downgrades because of the rise in their debt-to-GDP metrics. Thus, credit differentiation in the high-quality bracket is also essential for generating strong alpha in the asset class."
Countries that we place on the mid-quality spectrum have a wide array of credit characteristics. Some governments have manageable debt levels but low levels of domestic savings and/or insufficient domestic debt markets, which limits financing flexibility. They include countries such as Paraguay, Jordan, and Mongolia, which have relied on a combination of external debt placements and subsidized lending from multilateral institutions such as the International Monetary Fund and World Bank. They also receive funding support from the U.S. and other developed countries.
This segment also captures other larger countries with more stressed debt metrics but deep domestic savings and well-developed local markets, enabling governments to fulfil their financing needs. Countries including South Africa and Brazil have financed significant amounts in their local debt markets, often with short maturities, in order to keep the cost of debt service down. These local issuances have kept pressure off of credit spreads but have increased rollover risks in their domestic markets.
While little is expected on the fiscal consolidation front in the near term, these countries will need to develop medium-term plans to achieve debt sustainability. "They retain ample access to the external markets, but credit spreads will increasingly differentiate based on the market’s perception of the efficacy of their medium-term consolidation plans, as well as the political ability and willingness to implement them," said Mr. James.
Low-quality and distressed countries that entered the crisis with stressed balance sheets have been much more constrained in financing the unexpected shock to public finances brought on by the pandemic. Select countries in this group, including Bahrain and El Salvador, have been able to access external debt markets but have done so at high interest rates.
Most countries in this category have been much more dependent on subsidized multilateral funding and bilateral debt relief through means such as the G20's Debt Service Suspension Initiative. This group also includes distressed countries forced to restructure market-based debt, including Ecuador, Argentina, and Lebanon. It's worth noting that many of these fiscal woes were accumulated before 2020 and further exacerbated by the crisis.
"Government debt in low-credit-quality countries varies drastically," said Mr. Pradhan, "And predicting the fiscal trajectory right will be a major performance differentiator for emerging markets debt managers going forward." Governments will face a difficult balancing act in finding fiscal consolidation measures while continuing to rely on multilateral funding and further bilateral debt relief—especially from China, because of its role as a major creditor to many of these countries. Sri Lanka falls in this low-quality category that faces hard policy choices to maintain debt sustainability.
"There will be additional defaults and restructurings in these categories in the coming years," said Nick Eisinger, an emerging markets credit analyst based in the U.K., "but that will present strategic investment opportunities for active emerging-debt managers with deep fundamental research embedded in their investment processes."
Vanguard believes that one of the biggest risks to the performance of high-quality emerging markets debt is a rise in U.S. interest rates. U.S. rates are expected to stay low, continuing to support country fundamentals. But with credit spreads at historically tight levels, even a modest rise in rates likely would hurt investment returns on high-quality bonds. Credit spreads at the higher end of the quality spectrum simply don’t have enough room to absorb losses from rate increases.
The weakest part of the market, so-called distressed countries, is also a concern. Lower-quality countries may not address medium-term concerns about financing, whether because of a lack of a plan or a lack of political will, raising the probability of more defaults among them.
That leaves Vanguard favoring medium-quality debt over very high- and very low-quality debt. This offers some protection from a rise in U.S. rates and the potential for issuers’ fundamentals to strengthen should the global economy improve.
"In terms of country allocations, the duration and degree of any economic slowdown and government balance-sheet deterioration are going to vary significantly among emerging markets," said Mr. James, "adding to the case for deep fundamental analysis and active management."
Credit analysts Micah James, based in the United States; Nick Eisinger, based in the United Kingdom; and Nishan Pradhan, based in Hong Kong, provide fundamental research coverage of sovereign and quasi-sovereign debt issuers in their regions for Vanguard Emerging Markets and Sovereign Debt Team within our Active Taxable Fixed Income Group.
The Emerging Markets and Sovereign Debt Team manages $12.7 billion globally in fixed income assets (as of September 30, 2020), expressed in U.S. dollars, including $10 billion in emerging markets assets.