Emerging market debt saw a record net inflows of ~USD55bn in 9M21 driven by investor’s hunt for yield as spreads in low interest rate environment and weakening US dollar
EM corporate debt issuance has hit a record high this year. The trend is not surprising, as several factors stack up in favour of EM corporate issuance:
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On the demand side, lower interest rates and QE have pushed global asset managers to chase higher yields.
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On the supply side, EM corporates are using this opportunity to refinance and lower debt costs, as liquidity will likely remain supportive over the next 12-15 months before the beginning of interest rate hikes.
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Improving economic activity, strengthening currencies and higher commodity prices have remained supportive of the credit profile of EM corporates and their financial metrics. As such, EM corporates have leveraged this opportunity and raised debt.
The probability of rising issuance also poses higher credit risks, with growth affected by slow vaccinations and delays in recovery, due to the rapid spread of the Delta variant. Other factors that would affect EM corporate credit risk are as follows:
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The increasing issuance in EM isn’t necessarily a risk, as the fundamentals of EM corporates remain strong. For instance, net leverage of HY issuers in EM was c.3.0x compared to 5.0x for US HY issuers as of 2020 (vs 2.5x and 3.5x, respectively, in 2019), despite higher spreads on EM debt. To put this in perspective, the default rate of EM HY corporate debt was 3.5%, while that of US HY corporate debt was 7.0% as of March 2021, as per Goldman Sachs.
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The risks of an uneven recovery and lockdowns pose a threat to corporate fundamentals. For instance, infections in EMs are higher and vaccination rates lower compared to those in developed economies. As of June 2021, 43% of the population in DM were vaccinated, compared to the 27% global average.
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Larger risks to EM corporate could be rising US rates (and, consequently, a strengthening US dollar) and political and regulatory challenges (as seen in China).
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Rising domestic interest rates in EM economies (e.g., Korea recently hiked interest rates, while Brazil has already hiked rates four times this year) pose a threat to the nascent recovery and is a risk when the US raises interest rates, limiting the headroom for EM economies.
Certain EM countries could pose higher credit risk due to idiosyncratic issues. In more details:
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Countries at greater risk in EM are those with high exposure to external funding and political uncertainties such as Turkey, Colombia and Argentina. Credit risks in these countries are more idiosyncratic rather than systemic, apart from the sectors impacted by COVID.
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On the other hand, compared to the last taper tantrum, countries such as India, Brazil, Indonesia and, to some extent, South Africa have narrowed their trade deficit and most have managed to enhance foreign reserves. This would limit local currency depreciation as and when the Fed raises interest rates.
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The financial sector, which is pro-cyclical and has benefited from government support and forbearance measures, is generally attractive when the economy picks up. Furthermore, the majority of banks have strengthened their capital position (through dividend cutbacks).
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Having said that, the reversal of forbearance measures (probably in 2022) and payment holidays could result in marginal credit deterioration, especially in banks more exposed to COVID-impacted sectors (travel, leisure and retail) and unsecured lending.
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Certain EM sectors also pose higher credit risks than their developed counterparts, specifically:
- We believe that sectors such as leisure (gaming and hotels), non-essential retailers (branded apparel, electronic goods, etc.) and tourism (aviation and shipping) are risky given the higher chances of business disruptions due to lockdowns.
- The real estate and IT sectors – more impacted by regulatory changes and government clampdown in China – are also staring at bigger risks.
