World Economy

EM Debt Has Troubling Spots

EM Debt Has Troubling SpotsEM Debt Has Troubling Spots

Investors are deepening their love affair with emerging-market debt at a time of profound complacency in stocks and bonds. As they do so, some buyers may be disregarding some fundamental facts.

Emerging-market debt is generally becoming less creditworthy. Bloomberg Intelligence’s Damian Sassower pointed this out in a recent report, highlighting how lower-rated countries including Turkey, Ecuador and Sri Lanka are selling a greater proportion of new debt.

Investors poured record amounts of money in the biggest emerging-market debt ETF this week. This is evident by examining the composition of the biggest emerging-market bond exchange-traded fund, which received a record amount of new money this week.

The fund, iShares J.P. Morgan USD Emerging Markets Bond ETF, tracks a benchmark that’s broadly used as an investment guide. The proportion of this fund’s holdings rated in the BB tier and below (or unrated) by Moody’s Investors Service has increased to 48.1% from 44.7% in June 2015, data compiled by Bloomberg show.

There are some well-known problem spots among developing countries, such as Brazil and Venezuela, which are carefully studied by hedge funds and active fund managers. But other less-publicized countries that have checkered histories when it comes to repaying debt are starting to borrow more money.

Consider Nigeria, for example. Its Zenith Bank just sold $500 million of bonds, the first effort by any Nigerian bank to access the hard-currency market since 2014, according to Bloomberg Intelligence. Nigerian companies, banks in particular, have frequently opted to default in the past, including Seven Energy and Sea Trucks.

This increasing risk on a fundamental level isn’t being reflected by yields. Average rates on emerging-market debt have fallen sharply this year, especially compared with similarly rated US corporate bonds.

This makes sense from the every-central-banker-is-handing-out-free-money perspective. It’s cheap to borrow in the US and Europe and expensive to invest. Why not use cash from those markets to buy higher-yielding securities, like those in less-established nations?

Also, the global economy has shown signs of life in recent months, especially as China manages to avoid a messy end to years of meteoric growth, and these economies stand to benefit. It also helps that the US dollar has weakened, making it easier for developing nations to repay their greenback-denominated debt.

But beneath this rosy veneer is a more mixed picture. Investors who are plowing into emerging-market index funds are getting mixed up in situations that are bound to become messy, if they aren’t already.

Meanwhile, an increasing amount of hard-currency debt from these nations is coming due starting in 2018. By then, broader sentiment may change quite a bit.

Investors may ignore these blips at a time of ultra-low yields in the developed world, but they’ll pay more attention if US and European rates rise. They’ll also pay more attention if distress starts to spread.

Many bond buyers see emerging-market debt in a sweet spot. There may be some good opportunities, but there are some troubling spots as well. It’s time to be more selective.

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