Covid and emerging market debt: Walking a tightrope

6 Oct 2020

Emerging markets are likely to become a key victim to the Covid pandemic, with rating agencies predicting a wave of defaults. So, what are the potential consequences for institutional investors with exposure to the asset class?

Emerging markets are set to be a major victim of the Covid pandemic with rating agencies predicting a wave of defaults.

Emerging market debt has been on the agenda for many of the UK’s defined benefit (DB) schemes for some time. With returns on gilts shrinking and maturing schemes looking to expand their fixed income portfolios, many have broadened their horizons by gaining exposure to the developing world’s huge economic growth projections.

Examples include LGPS Central, which awarded a £900m emerging market bond fund mandate, and £46bn LGPS pool Border to Coast, which has included emerging market debt in its £2.7bn Multi-Asset Credit fund. By May, the £9bn Centrica Pension Schemes had around 8% of their assets invested in emerging market debt, all of which is denominated in local currencies.

The Covid pandemic has swept the world with almost all countries reporting some level of infection, yet some emerging market nations have been hit harder than most. At the time of writing, India counted more than 6.3 million infections resulting in almost 100,000 deaths, with Brazil, Russia and Colombia not far behind.

Responding to these challenges is expensive. Back in March, a conservative IMF estimate put the emerging market financing needed to tackle the crisis at some $2.5trn (£1.9trn). But in the first half of 2020, private capital flows into emerging markets dropped from more than $50bn (£38.5bn) in January to -$230bn (-£177bn) in May, according to the National Bureau of Economic Research.

The plunge in private capital inflows forced multi-lateral organisations such as the IMF, the World Bank and regional banks to step in. As of May, they provided almost $150bn (£115bn) in emergency funding, a drop in the ocean considering how rapidly infection rates are rising.

In the first half of this year, emerging markets also issued $124bn (£95bn) in hard currency debt in a bid to attract new sources of funding.

At first sight, their attempts appear to be successful. In September, emerging market fortunes turned as $12.9bn (£9.9bn) of debt flowed into those economies, despite equity markets reporting more than $10bn (£7.7bn) in outflows, according to the Institute of International Finance (IIF). But analysts remain cautious that the main challenges are yet to come. “Our data shows that a big “risk-off” is brewing in EM,” warns Jonathan Fortun, an IIF economist. “We are tracking high frequency outflows from EM in the final weeks of September almost as big as in the 2013 taper tantrum or during 2015’s RMB devaluation fears. And that’s with US election uncertainty only just coming onto radar screens,” he adds.

Debt issuance across emerging markets had already picked up sharply with average debt-to-GDP ratios rising to 59% from 36% in the five years to 2019 and is expected to reach 63% this year, the World Bank says.

While this is still significantly lower than debt-to-GDP ratios across advanced economies, emerging markets face higher debt servicing costs, particularly if their credit rating declines.

Earlier this year, Argentina, Ecuador and Lebanon defaulted on their debts and attempts to restructure their loans have been far from successful. Just days after returning to the capital markets, Argentinian debt is already trading at distressed levels. Fitch Ratings predicts that 2020 could be a year of record level sovereign bond defaults. As always, default risks vary significantly by country, with some nations tackling the Covid crisis better than others. “The sovereigns most exposed are those with generally weak credit fundamentals, such as high debt and weak policy credibility; and those reliant on commodity exports or tourism, or with large external financing requirements, foreign-currency debt, hot-money inflows and low reserve buffers,” the rating agency warned.

The effects of Covid also vary between hard-and soft currency debt. While issuers with hard-currency denominated debt should initially benefit from a weaker dollar, much of their trade is already priced in dollars, which offsets the beneficial effects of a cheaper greenback. Meanwhile, domestic-currency issuers face a double whammy of currency volatility and weaker growth rates.

Over the coming months, emerging market bond issuers and investors might find themselves walking a difficult tightrope. On the one hand, additional capital is sorely needed, and many countries are keen to increase borrowing. Many investors might also see this as an opportunity to capitalise on the additional returns provided by bonds with a rapidly declining credit rating. But the line between financing the recovery from Covid and funding an unsustainable debt burden may in some cases be very fine.

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