Emerging Markets as an Extension of US Credit

Western Asset on why the time is right to look at emerging market debt as a core, “extension of US credit” secular allocation.

    Kevin J. Ritter

    Mark Hughes

    In our recent client travels (virtual, of course!), Western Asset has noted that our insurance investor base is increasingly viewing emerging markets (EM) debt as an opportunity in a post-pandemic, reflationary environment. We believe now is the time for general account insurance assets to look at EM not as an opportunistic, total return play, but rather as a core, “extension of US credit” secular allocation.

    EM’s Income Advantage

    Many investors are aware of the income pickup that investment-grade-rated EM debt offers relative to similarly rated developed market (DM) opportunities. This premium has historically been at least 50 basis points, but you may be surprised to hear that current EM differentials trade toward the wider end of a five-year range (Exhibit 1 – blue line), despite the recent compression in global yields.

    We would note the current investment-grade-rated EM opportunity set has fundamentally strengthened from prior periods, with cuspy issuers such as Brazil, Turkey and South Africa no longer part of the universe, likely reducing volatility going forward. Furthermore, the ratio between EM and DM yields (Exhibit 1 – green line) is at a historically wide level. Investors are receiving the same income pickup in today’s low-yield environment that they were during periods of much higher rate structures. Said differently, we believe investors currently have the opportunity to allocate to a segment of EM with historically strong fundamentals at an attractive entry level.

    Exhibit 1: EM vs DM Yield Comparison

    Note: EM Yield = 50/50 EMBI Global Dividend and CEMBI Broad Dividend Yields; DM Yield = Bloomberg Barclays Corporate Index.

    Source: Bloomberg. As of 31 Dec 20.

    Comparing Default Risk

    If the attractive attributes of EM credit (e.g., income, diversification and total return potential) are relatively well known, we believe investors’ perceptions of the sector’s risks are likely overstated and misunderstood. A common investor concern is the likelihood of downgrades and impairments in the EM sector relative to DM; however, data suggest such occurrences in EM are no more frequent than in DM. Exhibit 2 shows S&P’s cumulative historical default rates by ratings for EM and US credit. As the table illustrates, EM has a lower default rate in A and BB ratings categories and relatively equivalent rates in the BBB category.

    Exhibit 2: Cumulative Default Rate by Ratings Category—1980 to 2019

    Source: S&P. As of 9 April 2019.

    We believe these data suggest the ratings agencies do a reasonably good job of assessing credit quality between EM and DM. Given equivalent credit risk and a yield premium for EM, insurance companies can take advantage of this additional income per unit of risk. Despite there being a perception among investors that EM is a more volatile asset class, the data seem to suggest the opposite. The drawdown chart in Exhibit 3 shows that BBB rated EM debt has performed comparably to US BBBs under stressed market conditions.

    Exhibit 3: EM vs. DM Drawdown Comparison

    Source: Bloomberg, Western Asset. As of December 2020.

    The Value of EM in a Post-Pandemic World

    In summary, investors may look toward EM as a potential top performer as we enter 2021 and start to look beyond the COVID-19 pandemic.



    DEFINITIONS

    "AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."

     

    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.