Emerging Market Debt Rallies On A Wave Of Liquidity

Why a selective approach that evaluates bonds country by country is best for emerging market debt investing.

Franklin Templeton Fixed Income

On the back of a second-quarter rally across emerging market debt (EMD), sovereign bond vulnerabilities still vary significantly by region and country. Lower oil prices offer a boost to oil importers like the Dominican Republic, but if prices fall back to the US$20– $30 range it could spark a solvency crisis for some oil exporters. This paper showcases two oil-exporting sovereigns, Angola and Iraq, which still offer upside opportunities despite headline risks. As Africa’s second-largest oil exporter, we believe Angola’s prospects rest heavily with China, its chief export partner and lender. For Iraq, its big hurdle isn’t a large debt burden; rather, it is restructuring the state’s public payrolls and pension obligations amidst rising poverty.

Emerging markets ended the first half of 2020 on a note of confidence, even as the COVID-19 pandemic accelerated in parts of Latin America and elsewhere. Initially kicked off by the US Federal Reserve’s (Fed) “shock and awe” policies, a tidal wave of central bank stimulus and quantitative easing (QE) spilled over into the developing world, putting a floor under risk assets. In a handful of emerging countries like Indonesia and South Africa, central banks are also buying their own government bonds, though with noticeably less fire power than the Fed or the European Central Bank.

All combined, the relief rally in EMD is welcome news; that said, returns remain bifurcated between investment-grade sovereigns, which are positive through June, and high-yield bonds, which remain modestly down. Given uncertainties over COVID-19’s trajectory, many investors remain cautious toward high yield. Investing with confidence requires deep bottom-up analysis as each sovereign faces unique hurdles.

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What Are the Risks?

All investments involve risks, including possible loss of principal. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. 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.