When engaged in our favourite pastimes, an hour can feel like a second. But when you sit on a red-hot cinder, a second will seem like an hour. That's relativity. And when investors are on the wrong side of a market pull-back they can experience the same kind of relativity: a region that they previously held as a long term exposure suddenly becomes a painful liability. This shift of perspective often pushes investors towards indiscriminate selling. Emerging markets (EM) high-yield debt fast became that red-hot cinder in 2013 as tapering fears drove investors towards developed market (DM) debt.
However, as the spread ratio of EM high yield to DM high yield widened, we found there was still plenty of opportunity despite the prevailing pessimism. Our preference at the time, given that EM growth was slowing, was for higher quality global players – typically BBB-BB rated issuers with an EM domicile but significant operations in developed markets that generated substantial revenues. These types of companies stand to benefit from US dollar strength and are not overexposed to their local domestic economies.
Then in February 2014 the relative risk/reward dynamic began to turn: any decision to add EM risk was mostly predicated on the belief that DM high yield had become too expensive, particularly relative to EM debt (we analysed this opportunity in the March 2014 issue of Spectrum). As you can see from the chart below, the spread ratio of EM high yield to DM high yield subsequently declined but has now rallied back at an extreme level of 1.88.
Blowing out: spread ratio of EM high yield relative to DM high yield v 10-year Treasuries
Source: Bank of America Merrill Lynch, Bloomberg as at 6 January 2015.
So EM high yield again looks attractive on relative terms. However, in our view, the recent widening of EM spreads has been driven not by fears of US rate hikes (as in late 2013), but rather by general concerns over global growth and by the conflict in Ukraine.
This becomes clear when you look at the spread ratios for the three main EM regions: Asia, EMEA and Latin America. All three regions widened in tandem in 2013 on rate hike fears. But since March 2014, EM Asian debt (both HY and IG) has significantly outperformed both DM high yield and other EM regions – particularly EMEA, due to the conflict in Ukraine. Latin America also rallied but the re-election of Dilma Rouseff, whose interventionist policies spook investors, and growth concerns reversed sentiment.
So as in 2013, while we think there’s a lot of value within the EM debt space, we believe that it’s imperative to be very selective as idiosyncratic and geopolitical risk has increased over the past year, making security selection even more important. Furthermore, we still think that focusing on higher quality global businesses with BBB-BB ratings is the way to play the EM space.