PORTFOLIO Bonds & fixed income

Your Emerging Markets Bonds Allocation May Now Be “Junk”

Investors are once again focusing on emerging markets credit risk given the recent high-profile ratings downgrades of China, Brazil, and South Africa. T

he overall credit quality of the hard currency emerging markets debt market has declined significantly since 2013. More than 51% of the J.P. Morgan EMBI Global Diversified Index ("Index") was rated high yield or "junk" as of May 31, 2017, versus just 34% at the end of 2013. This means that emerging markets bonds investors are likely to have more "junk" in their portfolios, and are assuming significantly more credit risk than they were only four years ago. Since 2013, the average emerging markets bond rating has dropped from BBB- to BB+. At the same time, yields and spreads have tightened, and investors are getting paid less to assume more risk.

Ratings Downgrades Have Increased…
Why worry about the "junk"? Because there is more of it. Moody's downgrade of China in May received the most attention, but had less impact on investors given its lack of presence in emerging markets bonds indices. On the other hand, Brazil and South Africa suffered ratings downgrades that have had a greater impact for investors. Both countries have been punished by elevated political risks that have threatened key fiscal and economic reforms. South Africa was downgraded by both S&P and Fitch from investment grade status to high yield status. Brazil, which was placed on negative watch by S&P, lost its investment grade rating in 2015.

VanEck your emerging markets bonds allocation may now be junk1
…Even as Spreads have Tightened
Since the end of 2013, the spread on the J.P. Morgan EMBI Global Diversified Index is essentially unchanged. However, breaking the Index into high yield (HY) and investment grade (IG) subsets tells a different story. Both segments tightened, but the high yield portion tightened more than investment grade (in both absolute and percentage terms). Because of the higher tilt towards high yield over this period, this tightening has been less evident at the overall Index level.

VanEck your emerging markets bonds allocation may now be junk2
Where Can Investors Find Value? Look to Higher Quality and Local Currency Bonds
With higher credit risk and tighter spreads, where can investors find value? One option is to focus on the higher quality portion of the J.P. Morgan EMBI Global Diversified Index. For example, the J.P. Morgan Custom EM Investment Grade Plus BB-Rated Sovereign USD Bond Index, which is comprised primarily of investment grade rated bonds with a limited BB rated allocation, had a yield of 3.74% as of May 31, 2017. That equated to a nearly 60 basis points pickup in yield versus U.S. dollar-denominated investment grade corporate bonds as measured by the Bloomberg Barclays U.S. Corporate Bond Index. Alternatively, investors may consider local currency sovereign emerging markets bonds to address credit risk concerns. Unlike the hard currency market, the universe of local currency bonds is still rated investment grade, on average. There are a few reasons for this. First, debt denominated in an issuer's local currency is often rated higher than foreign currency denominated debt (e.g., U.S. dollar or euro) by the same issuer. That is because foreign currency movements do not directly impact the ability of the country to repay its local currency-denominated debt. Further, the countries that are able to issue local currency debt globally tend to have larger and more developed local markets that are accessible to foreign investors. More open markets and less external vulnerability generally translate into higher credit ratings. Investors assume the foreign currency risk by investing in local currency bonds but have reduced credit exposure and earn higher yields.