With inefficiency comes opportunity, according to Franklin Templeton Fixed Income\u2019s Nicholas Hardingham and Robert Nelson. They consider the emerging market debt landscape, and what the remainder of the year could bring for the asset class.<\/p>\n
A rally in emerging market debt assets has gained traction following a very difficult period starting from March, which we consider to be one of the worst months in the history of the asset class\u2014on par with the global financial crisis.<\/p>\n
The demand, supply and oil shocks that hit the global economy and capital markets were exacerbated in the case of emerging market debt by extreme outflows, which manifested in indiscriminate selling of exchange-traded funds (ETFs).<\/p>\n
Macroeconomic factors have mostly driven the rally, along with the US Federal Reserve\u2019s (Fed\u2019s) extraordinary liquidity provision in March that really turned the tide. Some recovery in the price of oil to its present level around US$40 has also played a part in the rally.<\/p>\n
We consider liquidity a factor intrinsic to the asset class that contributes to the inefficiency of the market, which thereby creates opportunity. While the general trend since the Fed\u2019s liquidity injection has been a tightening of spreads, helped by a significant improvement in trading conditions, liquidity remains a major factor and its absence has certainly caused significant volatility for individual bonds.<\/p>\n
A patient approach is often needed to source bonds at attractive prices. We also like to look for opportunities beyond standard benchmarks to debt instruments which have sufficient liquidity premium priced in.<\/p>\n
Several factors have continued to provide liquidity to the emerging market debt market. The Fed\u2019s decision to buy investment-grade US bonds has had a trickle-down effect, while the International Monetary Fund\u2019s emergency financing has supported some specific countries and central banks. Within emerging markets themselves, governments and central banks are also providing significant counter-cyclical support. And, as we\u2019ve\u00a0previously<\/a>\u00a0mentioned, successive crises over many decades have encouraged better management of public debt stocks. This has resulted in improved credit quality as well as governance in emerging markets, creating resilience against further shocks.<\/p>\n Despite the general improvement in trading conditions, we have seen a bifurcation of the market, with stronger sovereigns and corporates rallying back towards pre-crisis tights, while other weaker names continue to reflect illiquidity and elevated default risk. Primary market activity has been skewed towards investment-grade issuers for sovereigns and corporates, however.<\/p>\n In the last week of June, we saw some strong issuance from B and BB sovereign issuers. We\u2019d largely expect this trend to develop as the remainder of 2020 plays out against a backdrop of macro-driven factors such as government policies and continued improvement in the global economy.<\/p>\n For corporates, we saw a turning point in what would have been a vicious cycle into a more virtuous cycle. It\u2019s worth recognizing that there have been significant forbearance measures\u2014a temporary pause on repayments\u2014and macroprudential loosening in the emerging economy, similar to what we\u2019d seen in developed markets, which has allowed some confidence to eke back in.<\/p>\n Year-to-date, emerging market corporate bonds in aggregate have recovered around 60% of their increase in spread over US Treasuries, but have already broken even on a total return basis.\u00a01<\/sup><\/a>\u00a0We have seen a handful of emerging-market corporates default so far, and our expectation is that the default rate should likely trend upward to high single digits over the remainder of the year as those industries particularly exposed to the COVID-19 crisis, such as retail and transport, remain under pressure.<\/p>\n However, historically, emerging market corporates have been no more prone to defaults than their developed market counterparts, so we see no reason currently why this will not remain the case. It\u2019s also worth remembering that high-yield bonds only account for around a third of the universe of emerging market corporate bonds, which is a much lower proportion than many people expect.2<\/sup><\/a>\u00a0This means that the default rate for the asset class as a whole will likely remain in the low single digit percentage, in our view.3<\/sup><\/a><\/p>\n As spreads continue to tighten over the course of the year, there will undoubtedly be bumps. Companies themselves have been able to issue bonds in a similar manner to sovereigns\u2014issuance has been US$237 billion year-to-date, only slightly behind 2019,4<\/sup><\/a>\u00a0though skewed heavily towards the investment-grade part of the market, and Asia. We see positive signs that many companies have been able to refinance, enhance their liquidity positions and draw down on credit lines. And in some cases, they have been able to garner support from government stimulus packages.<\/p>\n In the short term, some bonds in certain markets arguably have rallied too far, too fast. From a fundamental perspective, there is now the prospect of a range-bound period of consolidation until we see second-quarter gross domestic product figures. Questions remain over the valuations of all asset classes in what is an unprecedented period for markets. We largely expect more volatility, but perhaps less so than in the first quarter.<\/p>\n Over the longer term, interest rates in developed markets now look to remain low, so we expect emerging markets that offer an attractive spread will be in demand. At the same time, we think the asset class continues to offer diversification for many investors.<\/p>\n This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.<\/em><\/p>\n Data from third party sources may have been used in the preparation of this material and Franklin Templeton (\u201cFT\u201d) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.<\/em><\/p>\n Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and\/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.<\/em><\/p>\n Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN\/342-5236, franklintempleton.com\u2014Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton\u2019s U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.<\/em><\/p>\n All investments involve risks, including possible loss of principal.\u00a0<\/strong>Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. Actively managed strategies could experience losses if the investment manager\u2019s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager\u2019s investment techniques or decisions will produce the desired results.\u00a0Diversification does not guarantee profit or protect against the risk of loss.<\/p>\n CFA\u00ae and Chartered Financial Analyst\u00ae are trademarks owned by CFA Institute.<\/em><\/p>\n _________________________________________________________________ 2.<\/a>\u00a0ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, June 2020.<\/p>\nImportant Legal Information<\/em><\/strong><\/h2>\n
What Are the Risks?<\/strong><\/h2>\n
\n1.<\/a>\u00a0 ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, June 2020. Past performance is not an indicator or a guarantee of future performance. Important data provider notices and terms available at www.franklintempletondatasources.com<\/p>\n