COVID-19's impact on emerging market debt

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The COVID-19 pandemic has had a significant global impact across all asset classes. Emerging market bonds (in US dollars) as of March 27, 2020 show a total return of -14.0% month-to-date and -13.5% year-to-date.

Emerging markets (EM) have seen huge spread moves, and valuations are now attractive as the risk premium has not been this high since the financial crisis in 2008. Risk premiums exceeded 700 basis points (bps) over US Treasuries in mid-March – looking back more than two decades, this level was only reached during the global financial crisis, where spreads traded above 600bps for two quarters only. Last week was characterized by a drastic recovery, and spreads tightened by almost 100bps to 624bps. For investors with longer time horizons, we believe the current spread level is very attractive.

The role of central banks

The EM policy response differs from previous crises as many EM central banks have been able to cut interest rates, despite weakening currencies. With higher risk premiums, EM countries face potentially higher funding costs, but the rally in US treasuries has kept all-in yields reasonable for countries with better fundamentals. Recently, the Republic of Panama issued long-dated bonds due in 2056 paying a 4.5% coupon. This interest expense is not too dissimilar from where the country issued long-dated bonds previously, although the spread was much wider. Furthermore, many EMs have access to alternative sources of funding – for example, local markets for more developed countries, or bilateral and multilateral support, which can limit funding pressures.

The scale of the policy response in developed markets has been very large and should help to soften the impact from the virus. The US Federal Reserve (Fed) cut interest rates effectively to zero and announced unlimited Quantitative Easing. After the decision, the Fed’s balance sheet rose quickly from US $4 trillion to an all-time-high of US $5.25 trillion with no immediate upper limit. The US fiscal package of US $2 trillion is worth around 10% of GDP if fully drawn. Many other countries have also announced fiscal and monetary measures to cushion the effects from COVID-19. This makes us hopeful that income levels can be maintained to some degree, and consumers as well as business confidence can improve quickly as the virus recedes.

Population considerations

Looking more closely at the effect of the virus on EMs, we can first note that these countries typically have very young populations. The share of the population aged 65 and above is less than 10% – much smaller than the 20% share in developed markets – as shown in the chart below. The ‘at risk’ group is therefore much smaller in EMs compared to developed markets, but health systems in the former are a lot weaker.

Percentage of population above 65 years old

COVID-19 and EM debt - Percentage of population over 65

Source: World Bank Indicators, as of March 18 2020

Some EM countries have responsibly locked down and prescribed rigorous quarantine measures, such as South Africa and countries in Eastern Europe. But others, for example many African nations, simply don’t have the institutional capacity to do this – and then there are also those countries with populist leaders who have defied expert advice, such as Brazil and Mexico, who together account for roughly half the population of Latin America.

It’s also about oil

In EMs, the market move is not only driven by COVID-19 fears, but also due to the precipitous fall in the oil price from US $50 per barrel at the end of February to around $23 per barrel now. The decision by Saudi Arabia and Russia not to renew the OPEC+ agreement and subsequently to announce huge increases in production targets amid a sharp decline in demand due to COVID-19 put crude oil in a tailspin and exposed EM oil exporters to significant risks. The countries most at risk are those that rely on oil as a large proportion of exports and/or fiscal revenue. Within this group there are those that have large fiscal buffers (UAE, Saudi Arabia, Russia) and those that do not have significant savings funds (Angola, Bahrain, Nigeria). Against this backdrop, we reduced positions in oil exporters (Oman, Colombia, Nigeria) and increased exposure to oil importers (Dominican Republic, Hungary, Panama).

A protracted commodity war and long-lasting low oil price will not be supportive for EM asset class overall. However, we see the current situation and standoff between Russia and Saudi as unlikely to persist, as higher prices benefit both countries. Lower demand from the shutdown due to COVID-19 creates additional price pressures for oil, but ultimately, we believe that crude producers will strive to balance supply and demand in order to stabilize the situation.

Conclusion

Our strategy is to look for opportunities to re-invest in markets that now offer much better valuations, but given the challenges described above, we are looking to only selectively re-enter. Overall, we believe that markets will need to see some stabilization in new cases for COVID-19, as well as gain visibility on how the economic recovery will shape up. But looking at the repricing of equity markets, 10 year US interest rates below 1% and yields near zero in Europe, a considerably negative scenario is already reflected in markets. We also think the extreme negative price action was somewhat technically driven – risk parity failing, banks under Volcker rule, traders quoting defensively as most now operate from their homes due to the lock down in major trading centers.

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Disclosures

Investing in emerging markets is generally considered to involve more risk than developed markets.

Keep in mind that as interest rates rise, bond prices fall. This may have an adverse effect on a fixed income portfolio. A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

Views and opinions have been arrived at by BMO Global Asset Management.  The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

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