Demystifying emerging market sovereign debt as a reflation trade

Demystifying emerging market sovereign debt as a reflation trade

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  In this analysis, we look at emerging markets sovereign bonds to understand whether they can be a better investment than junk corporate bonds amid an economic recovery. Although we find that China, Russia, India and Mexico offer good opportunities, we remain cautious of EMs as a whole. Indeed, EM sovereigns are exposed to high refinancing risk amid rising interest rate in the United States. Yet, Chinese local currency government debt might provide diversification in ones' portfolio while the yuan renminbi becomes one of the largest reserve currencies.


Since the beginning of the year, we have talked long about US high yield corporate bonds and how they can provide a cushion against rising inflation expectations. However, we have not touched upon one of the market's favourite trades: emerging markets (EM). The logic supporting long EM positions is simple: as the economy reopens and the US dollar weakens, EMs will flourish. Yet, I remain suspicious about such convictions for the simple fact that rising yields in the US cannot be a positive trend for EM assets.

The topic has recently attracted more attention as US junk corporate bonds now pay investors less than US dollar EM sovereign debt. Still, the macroeconomic backdrop that these assets can benefit from is entirely different. Indeed, the US market is heading towards a sure economic recovery. Still, EM countries lag behind amid a slow pace of vaccinations and a weak economy.

Source: Bloomberg and Saxo Group.

EM sovereign debt is risky like never before

In the past five years, EMs have been running a policy of twin deficits and economic imbalances, provoking an exponential rise of EM debt-to-GDP ratio. According to the IMF, in 2020, these countries' debt-to-GDP ratio has risen from 55% to nearly 64%. The monetary fund estimates that EM will need to borrow even more money in the next five years, calculating the ratio to hit 71% in 2026. The most troubling part is that while more debt is issued, the spread that EM USD sovereign bonds offer over the US safe haven remains stable, below the twenty-year average. It means that investors are not compensated for the risk of holding increasingly indebted EM markets.

Another troubling factor is that while EM sovereigns are extremely volatile during a crisis, their tightening potential over US Treasuries seems limited. Indeed, the option-adjusted spread (OAS) of USD EM sovereign bonds have traded rangebound for twenty years. During the global financial crisis and last year's Covid-19 pandemic, spreads spiked, breaking above their resistance line. Now EM spreads look heading towards the lower support line, signaling that upside is defined while the downside is unlimited.

Source: Bloomberg and Saxo Group.

Our favourites: China, Russia, India and Mexico

The biggest reason we don't like EM sovereign bonds lies in the recent rise in US Treasury yields. Yields are rising in the United States because inflation expectations are rising. Although the Federal Reserve will ignore a real rise in inflation by keeping monetary policies easy, the US yield curve will steepen. A steeper US yield curve poses a severe refinancing threat to the developing world.

At the end of last year, we built an "EM distressed monitor”, trying to understand which countries were posing a more considerable risk to bondholders. Today, we update that chart to understand which countries offer the greatest risk.

We find that market sentiment has improved across all EMs except for Argentina, in which CDS spreads have widened. It matches our findings above, which show that the average EM OAS over US Treasuries has tightened. Secondly, we see that in 2020 nearly all countries increased their debt-to-GDP ratio. Finally, each one of these countries' central bank has engaged in accommodative monetary policies.

Expansionary monetary policies in the EM can be a double edge sword. On one side, it supports internal markets; on the other, it provokes a devaluation of the local currency, which can prove extremely dangerous during an environment of rising interest rates. However, it must be said that countries with ample international reserves can engage in accommodative monetary policies without significant problems. That's the case of our favourite EM: China, India, Russia and Mexico.

The countries that prove the riskier, on the other hand, have low international reserves, a high debt-to-GDP ratio and have engaged in aggressive monetary policies. These countries can be found at the right end of the chart below.

Bond investors have the problem that the average yield offered by Chinese and Russian USD 10-year sovereign bonds is around 2%, representing a small pick up over the US safe-havens. Mexico, on the other hand, offers about 3% in yield for its 10-year USD bonds. It must be said that the risk of this country is not defined only by the elements above indicated. The highly indebted state-owned Pemex influences the country’s credit quality contributing to its risk.

We are increasingly looking at Chinese debt with interest because it proves resilient amid the recent rise in yields in the US. It may be a sign that the yuan renminbi is quickly rising as one of the largest reserve currencies. The stability of Chinese government bonds is remarkable even in light of the domestic financial sector's recent deleveraging. While the news regarding the distressed asset management Huarong hit the market, the 10-year Chinese international bond in USD (USY15025AC67) is stable together with the 10-year Chinese bonds in renminbi (CND10003VNX4). We believe that local currency Chinese government debt might provide an important diversification component in one’s portfolio as US Treasury yields continue to rise.

Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-sg/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Saxo Markets
Most of our staff in Singapore are working from home to help limit the spread of the coronavirus. We remain at your service on the details below. Thank you for your understanding.

Contact Saxo

Select region

Singapore
Singapore

Saxo Capital Markets Pte Ltd ('Saxo Markets') is a company authorised and regulated by the Monetary Authority of Singapore (MAS) [Co. Reg. No.: 200601141M ] and is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Risk Warning to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as Margin FX products may result in your losses exceeding your initial deposits. Saxo Markets does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Markets does not take into account an individual’s needs, objectives or financial situation.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-sg/about-us/awards.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website are not intended for residents of the United States, Malaysia and Japan. Please click here to view our full disclaimer.

This advertisement has not been reviewed by the Monetary Authority of Singapore.