Emerging market sovereigns might not offer enough protection against rising US yields

Emerging market debt could serve as a protection against rising US yields

Since the Covid-19 pandemic, easy monetary conditions caused an unstoppable rally and surge of negative-yielding debt. Spanish 10-year sovereigns last week were the latest to join the $18 trillions pile of sub-zero yielding debt, putting more pressure on investors that need to put money at work. Negative yields have been one of the reasons why investors started to look beyond their borders.

Initially, the market has been selective and picked only higher-rated EM paper which widened amid the coronavirus pandemic. Still, afterwards, investors ended up buying junk EM debt pushing yields lower and lower.

Spread compression this year has been substantial in both EM credits. On average, EM bonds are now offering the lowest yield in history. The Bloomberg Barclays emerging markets hard currency index indicates than on average EM US dollar sovereign bonds offer around 3.5% in yield.  Such conservative yield doesn’t deter investors from buying these securities, because what they look at is real yields. US 10-year real yields are now quoting at around  -1%  while Emerging real rates are much higher, giving investors a significant buffer against US rising yields.

Moreover, let's look at the option-adjusted spread that EM bonds offer over the US Treasuries. We will find that it is still wider than pre-global financial crisis historic lows. Therefore there is plenty of space for more tightening even if yields touched a historic low. Investors will continue to see upside holding EM debt, especially in light of soaring US rates.

Still, there is something that starts to trouble investors. EM bonds not only have become incredibly expensive, but they are now offering the highest risk in more than a decade. The option-adjusted duration measures the sensitivity of the price of the bond to changes in the swap option-adjusted spread (OAS). Emerging market debt OAD is currently at the highest level since before the global financial crisis pointing to the fact that defaults may rise withing weaker EM bonds.

Thus, even though emerging markets are poised to an unprecedented recovery next year, some investors remain cautions.

Emerging market sovereigns bring opportunities and challenges too

When investing in emerging markets, investors look to maximize their risk and reward ratio. That's why many look to gain a pick up over the emerging market's average yield of 3.5%.  It makes sense to look for higher-yielding bonds; however, a higher yield is as essential as much as lower duration to hedge against rising Treasury yields. Nevertheless, when we look at EM sovereigns with a maturity of maximum 7-year, we find out that choices are limited.

The sovereigns that can offer a yield above 3.5% are the ones of weaker economies such as El Salvador, Iraq, Cost Rica, Ghana and Oman. The ones with the lowest CDS spread, thus less risky of the lot are Mongolia and Egypt. In our distressed debt monitor, Egypt scored quite badly. It means that at this moment in time higher-yielding EM sovereigns are offering more risk than upside to hedge against a hike in US interest rates.

Many of you would be interested to learn that, in the majority of the cases, when a government bond defaults it's because the country decides that it won't be able to repay its debt. Sometimes the government even chooses to default on public debt while continue to honour other credit lines. This was debated in length recently when Zambia was seeking to suspend interest payments without giving assurance of equal treatment with large lender China. It serves as an example that investing in a weaker emerging market is not always straightforward and that placing large amounts of cash in a specific EM bond might result in big losses.