Luc Dʼhooge, Head of Emerging Market Debt, Vontobel Asset Management
The pandemic is testing the resilience of developing countries and many investors fear a series of sovereign debt defaults as emerging markets grapple with the economic damage of the virus. While there will undoubtedly be an uptick in defaults from the low average rate of the last two decades, these worries are overdone. Contrary to widespread expectations in this difficult environment, many emerging market countries have been able to refinance themselves on the bond market. We believe that the technical and fundamental landscape of emerging market sovereign bonds provides investors with plenty of opportunities for superior long-term returns.
After the COVID-19 crash, developed market central banks injected huge amounts of liquidity into their own markets, which had a knock-on effect on emerging markets. The International Monetary Fund (IMF) provided further support, putting a stop to the plunge of emerging market assets. As a result, emerging market sovereign spreads have recovered and stabilized, but still remain at elevated levels compared to historical averages (see chart).
Given the deterioration of fundamentals, such as growth, trade debt and the fiscal situation, further spread tightening is unlikely to be linear, especially as long as investors’ sovereign debt default worries persist. Currently, emerging market sovereigns owe more than 8.4 trillion in foreign currency debt and about 730 billion US dollars will become due until the end of the year (source: Bloomberg). The fear is that certain countries will struggle to service this debt due to falling foreign currency reserves, weakening local currencies, reduced global growth and less central bank firing power. These considerations do have some merit.
Countries with pegged currency regimes are more vulnerable especially if they also have poorly diversified economies that are highly dependent on just a few commodities or on tourism. Since the beginning of the year, some developing countries have already defaulted or restructured debt: Argentina, Lebanon, Ecuador and now Suriname. Many more have seen negative rating actions, like downgrades, or have been placed on negative watch. Moody’s in particular has been very active here. This makes future downgrades more likely. The last rating upgrades happened in March in the Baltic area.
However, we believe that current spread levels price in exaggerated levels of defaults and or too low recovery rates which disregards the economic resilience of many developing countries as well as the commitment of global financial institutions to support them now. The market reactions have in turn created considerable return potential for active investors who are able to identify and seize value-driven opportunities that arise from common misconceptions around sovereign debt defaults or generally in moments when fear reigns.
When a sovereign debt default occurs, a process ensues where debtor and creditors try to secure an agreeable outcome to all parties. International financing institutions want to limit the consequences of a default and keep international debt markets functioning smoothly. So, contrary to common beliefs, they have a vested interest in smooth restructurings, which has helped to accelerate negotiations. In addition, the recent trend towards increased inclusion of collective action clauses (CAC) into bond issuances makes it much harder for aggressive creditors to block debt restructurings that satisfy the majority of bondholders. This trend of increased CAC inclusion has become a good remedy against debt restructurings becoming too complicated, if a large number of parties are involved in the process.
In fact, they have made lengthy negotiation processes like in Argentina, which dragged on for years in the early 2000s, less likely. In sum, sovereign debt restructurings wrongly have a reputation to be endless, painful and unsatisfying. On the contrary, many are resolved in reasonable timeframes at decent recovery rates with most parties negotiating in good faith.
Sovereign debt restructurings tend to price in a good deal of pessimism of investors who often overreact to default events and underestimate the chance of obtaining attractive recovery rates. This is why many bonds that just defaulted, or have a very high likelihood to default, trade well below their recovery value. For example, Argentina defaulted in May and an agreement now seems close since none of the involved parties wants a hard default. In light of this, we added a bit of Argentina since even the government’s current proposal offers substantial upside from current price levels. However, outcomes may be very uncertain, making risk diversification extremely important. That is why, in return, we partly reduced our overweight to Ecuador bonds, as certain bonds doubled in value since their March low. At the time of overweight reduction, negotiations were still in the early days and it was unclear how long negotiations would take.
With the COVID-19 crisis, it is important to remember that most default situations arise from a liquidity rather than a solvency issue, which mainly requires adjustments to front-end payments on outstanding bonds only. Today, many of these situations are resolved by switching cash coupon payments for payments in kind (PIK), whereby bondholders receive new bonds instead of cash, or by adjusting the amortization process of the bond. These measures are minor adjustments that do not necessarily have a big impact on the bond value. An example is Suriname’s 2023 bond, which was supposed to start amortizing in June. In agreement with the creditors, this was postponed by six months while maintaining the maturity date of the bond.
The COVID-19 sell-off was severe as it was amplified by the OPEC+ break-up and by investors’ confusion around the Debt Service Suspension Initiative (DSSI) announced by the IMF, the G20 and the World Bank. Yet the market recovery phase harbors many return opportunities, which, amongst others, could be found in debt restructuring processes. Investors willing to get exposure to these return sources should remember that investing in emerging market debt is not about avoiding defaults, it is about uncovering high-alpha opportunities at reasonable risk.