I’m generally bullish on emerging markets because of favorable demographics and low stock valuations. ETFs that focus on high tech businesses that benefit from the growing strength of the EM consumer have a lot of room to grow, as I discussed in a prior article on the Emerging Markets Internet and E-commerce ETF (EMQQ). It’s true that many emerging markets are littered with low return state owned enterprises, but evidence shows systematically avoiding simply SOEs can lead to better returns. The best emerging market businesses have strong balance sheets, and will thrive during the COVID-19 pandemic and beyond.
Nonetheless, from a macro standpoint there is building credit risk in emerging markets. The unprecedented buildup in government and private sector debt is not likely to end well. Large parts of the emerging market credit offer low returns and high risk. This current environment is especially concerning for the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), which focuses exclusively on US dollar denominated debt of emerging market companies and companies.
Source: Seeking Alpha
EMB crashed in March, but then quickly recovered. I believe it is likely to return to the March valuation again in the near future. To understand why we need to look at the long debt buildup in emerging markets, and the changes that occurred as a result of the COVID-19 pandemic.
The Long Debt Buildup
Easy money in the US has made it easy for emerging market governments to borrow cheaply. With developed market debt yielding less than zero for much of the year, investors seeking income have had to take more risk than they are accustomed to.
Emerging market debt was getting excessive well before COVID-19 started. Over a decade of record low interest rate had led developed world investors to reach for yield in ever more dangerous areas. This was highly favorable to countries like Ghana which issued bonds in 2019 that were oversubscribed seven times over, just a decade after being entirely dependent on multilateral institutions like the IMF and World Bank. Over and over again, countries with unstable political environments were able to issue debt at low yields and long maturities.
According to a December 2019 World Bank Report, we are a decade into fourth major wave of emerging market debt in the past fifty years. The prior 3 all ended in financial crises, and this current fourth wave is by far the largest and the fastest ever. Additionally, prior debt waves were regional, but this debt wave is global, impacting virtually all emerging markets.
This chart from the IMF shows emerging and developing market debt over the past 50 years:
Source: IMF- Caught by a Cresting Debt Wave–
In October 2019, the IMF noted that easy financing conditions had encouraged excessive debt buildup, raising sustainability risks. They were also concerned about the ability of emerging markets to rollover their debt. This debt buildup meant that countries would have limited ability to respond to a crisis.
Again, all these concerns were mounting prior to the COVID-19 outbreak.
Enter the Coronavirus
In response to COVID-19, emerging market countries implemented massive fiscal stimulus, just as capital markets were freezing up. In the first months of the pandemic, private capital fled emerging market debt markets, and the multilateral institutions stepped. Credit offered by multilateral institutions is generally super senior to any other debt. This super seniority can be challenged, but only in a lengthy and complex legal process.
The deteriorating fiscal conditions quickly impacted the creditworthiness of countries. Ratings downgrades in 2020 exceeded prior debt crises, as shown in this chart:
Source: IMF- The Debt Pandemic
Multilateral institutions and politicians have called for several policy initiatives, none of which are likely to be favorable to investors buying at current prices. The IMF is promoting a “Reform of the International Debt Architecture.” In general this is likely to mean pressure for debt service suspension, and for an orderly restructuring. However, restructuring is rarely orderly.
This chart shows how long sovereign restructuring typically take:
Source: IMF- The Debt Pandemic
The likely increase in downgrades and complex restructuring is especially concerning for EMB.
EMB’s portfolio focuses on sovereign debt, which accounts for 84.21% of the portfolio, and is well diversified by geography. Mexico and Indonesia have the highest allocations, at 5.23%, and 5.06% respectively. No other country comprises more than 5% of the portfolio. Yet the composition of the portfolio is becoming increasingly exposed to two other types of risk: credit quality and duration.
Currently ~40% of EMB’s portfolio is below investment grade. EMB’s portfolio is dominated by debt that is at the lowest rung of investment grade. In the coming months and years, downgrades in the sovereign credit market will likely cause this to shift, making the portfolio riskier and riskier. Yet investors at the current price will not receive any more dividends as compensation for the increased risk, and will likely experience permanent capital impairment from the current levels.
The following chart shows the composition of EMB’s portfolio by credit quality:
Source: Fund Website
EMB’s portfolio is heavily weighted towards longer dated issues. The effective duration is 8.58 years. The weighted average maturity is 13.67 years. Over 31% of EMB’s portfolio has a maturity of 20 years. It doesn’t seem prudent to be exposed to long term debt that was structured near the peak of a liquidity driven bull market in emerging market debt. This chart shows EMB’s portfolio by maturity:
Source: Fund Website
This longer duration debt is likely to suffer impairment, or at least be subject to extensions in a restructuring. Future debt restructuring is likely going to involve complex international litigation. Default workouts typically last longer than seven years. Many currently popular bonds might become illiquid in this situation. In an emerging market debt crisis, it would be difficult for the creation/redemption process to work properly for EMB investors (I’ve discussed a similar liquidity issue for US focused high yield bond funds, here and here).
EMB’s current yield of around 4.1% doesn’t compensate investors for the risks they are taking. Given the volatility in the market it is difficult to find reasonably priced options. Nonetheless, I’ll be looking to add to my puts on EMB in the coming weeks.
Disclosure: I am/we are short EMB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Note I am short via puts, not directly via the stock.