In our January blog post titled “Emerging Markets Debt: Can we earn that carry?” we defended the possibility of a continued recovery of the asset class after the strong start of the year. Our optimism has been rewarded: Through June, EM sovereign is up by 11.2%, leaving the losses of 2018 behind.
Such a strong first half of the year again begs the question: what comes next? We think there are three main reasons that emerging markets debt (EMD) will remain in demand as a source of quality carry: 1) the resurgence of a low yielding environment boosts the search for income 2) emerging markets debt offers an income pick up with solid credit quality 3) default rates in EMD remain low.
Technical tailwind from the search-for-income flows
Dovish shifts from global central banks this year have pushed a quarter of developed markets bond yields to negative territory again1. For EUR based investors in particular, less than half of Global Aggregate Bonds stock is yielding positively now. Emerging market debt has historically been a beneficiary of income-seeking flows under such a backdrop.
Better average quality behind the carry
EMD issuers, both sovereigns and corporates, have enhanced their balance sheets over the past years. EM sovereign index (EMBI Global Diversified) has returned to investment grade average rating after losing it in 2014. EM corporate net leverage is now at the lowest since 2013.
Comparable default and rating transition rates
As a result of the balance sheet improvement, we see EM in a better shape preparing for external shocks. The default rate for EM high yield corporate is estimated at 2.6% for 2019, which is below long term average. Moreover, despite the risk premium from having emerging market post codes, credit rating transition rates in EMD are actually similar with developed market counterparts (chart 4).
In the current low yielding environment, we believe investors’ search for yield will resume, resulting in demand for quality income solutions. With better average quality and lower leverage, we believe EMD should continue to stay on top of asset allocators’ mind for the foreseeable future.