For EM debt, the lower liquidity of recently volatile markets could provide more opportunity than in more tranquil times.
The Emerging Market (EM) asset class has evolved meaningfully over the years leading to differentiation in performance and liquidity. These are important factors and considerations for investors making strategic or tactical allocations to EM.
Difference in Performance Between Local, External Bonds and EM FX
With regard to local rates, yields initially rose sharply in March as global liquidity contracted aggressively. Despite growing market concerns around the size of the fiscal response required to put a flow under growth in key EM economies, yields have actually moved lower due to the implementation of accommodative monetary policies (e.g., rate cuts, open market operations and quantitative easing in some cases). As a consequence, local rates have been the most resilient EM sector, with positive returns offsetting the steep correction in FX.
Turning to foreign exchange, EM currencies (EM FX) weakened dramatically toward the end of 1Q20. Fundamentally, reduced implied yields and a weaker macro outlook have reoriented central banks to focus on generating growth over price stability. This combined with the propensity for foreign investors to invest locally, FX hedged, has put pressure on currency valuations. More recently, helped by improving prospects for global growth as economies slowly start reopening, EM FX has shown signs of stabilization and should do well in a broader risk-on environment.
The second observation is that EM hard currency spreads widened significantly as the crisis began and as investor outflows accelerated. Again, we see market liquidity challenges in the second half of March as the principal driver of this move. As policy measures started to underpin global sentiment and the pace of outflows started to abate, IG sovereign spreads turned the corner and have maintained a tightening bias since early April. This trend has remained steady despite robust primary market activity in IG over the same span.
The dynamic is notably different with respect to HY sovereign spreads, however. While market liquidity has improved in this segment of the market since late March, spreads only recently started to tighten. We see elevated external vulnerabilities in many of these economies—in conjunction with the Covid-driven shock to commodity prices, remittances and tourism—as a sustained headwind to spreads that will keep volatility elevated. While primary market activity may pick up on the back of the late rally, we think these openings will only occur in fits and starts. Market access will remain out of reach for a number of countries in the very near-term.
Investors have reduced exposure to the asset class following COVID-19 related volatility (Exhibit 1).
Exhibit 1: Cumulative Flows Into EM Bond Funds
Source: J.P.Morgan. As of 30 Apr 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Divergence in Liquidity Within EM
Liquidity in hard currency bonds has been on a steady decline since the global financial crisis (GFC). We think there are a few drivers behind this. First, and most importantly, the introduction of banking regulations after the GFC has limited the ability of banks to make markets and resulted in increased price volatility and wider bid/offer spreads.
Second, we see the proliferation of issuance from lower-rated countries as a contributor to weaker hard currency liquidity. Indeed, in single B rated credits specifically, we tend to see highly pro-cyclical market behavior. Demand for these credits can be insatiable, at times, when non-traditional EM investors flee low yields offered in developed markets and chase risk. Conversely, in periods of weakening risk appetite, these investors tend to exacerbate the downswing as they rush for the exit. In markets characterized by frequent alternation between risk-seeking and risk-averse investor attitudes, the pro-cyclicality of flows forces bid/ask spreads to widen materially.
Liquidity for EM corporate bonds has been poor as well, but this is primarily due to a lack of primary supply and low secondary volumes. What’s interesting here is that the lack of supply has generated a positive technical that has allowed corporates to outperform sovereigns with lower volatility. Another consideration has been that local yield curves in respective countries have fallen and corporates may find cheaper funding options domestically.
Over the last 20 years, local markets have continued to develop with more tenors, deeper market participation and overall lower yields. As local asset managers and pension funds grew, they became a natural buying base for local paper allowing for more liquidity.
EM currencies have generally been more liquid in terms of volumes traded and have also become the most volatile. They are a natural hedging tool for investors, which partly explains recent underperformance.
Exhibit 2: Evolution of the EM Asset Class
Source: Sectors represented by J.P. Morgan indices. As of 30 Apr 20. EMD USD Sovereign represented by J.P. Morgan EMBI Global Index; EMD USD Corporate Credit represented by J.P. Morgan CEMBI Broad Index; EMD Local Currency Sovereign represented by J.P. Morgan GBI-EM Global Index.
Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
A Closer Look at Recent Liquidity Stress Episodes—Signs of Recovery in Select Markets
Liquidity deteriorated severely toward the end of 1Q20 as COVID-19 spread and business shutdowns were announced globally. Markets at times felt broken as participants worked remotely with dealers bidding defensively for hard currency bonds—several points below indicated levels on their pricing runs. Local markets experienced similar price dislocations as foreign investors looked to reduce exposures and domestic players, that have generally been providers of liquidity, were on the sidelines. Prior to the recent stress, bid/offer in yield terms ranged from 3-10 bps in lower beta/liquid markets and 10-25 bps in more volatile markets. During the stress period, bid/offer spreads typically doubled and even tripled in some cases. Since then, we have seen a decent recovery in that indications are now transactable for both credit and local markets. Liquidity for derivatives also returned and interest rate swaps (IRS) as well as credit default swaps (CDS) became viable hedging vehicles again. EM FX remain the most liquid but are also first to react to macro and micro factors. Call it the relief valve for both economic and positioning imbalances.
Exhibit 3: Current Indicative Bid/Offer Spreads Across the EM Universe
Source: Western Asset. As of 22 of May 2020. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The market's varied and variable liquidity landscape is here to stay. Structural shifts in issuance patterns and industry regulations will ensure that's the case. The aftershocks of the Covid crisis will further contribute to this dynamic. But opportunities also arise in challenging times. Indeed, we were successful in monetizing meaningful new-issue premiums in the early stages of the market stabilization. And we will remain vigilant of risks, and mindful of opportunities, that can contribute positively to risk-adjusted returns going forward.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARSCoV-2.
A pandemic is the worldwide spread of a new disease.
Hard currency refers to a currency, usually from a highly industrialized country that is widely accepted around the world as a form of payment for goods and services.
Foreign exchange (FX) refers to markets for trading currencies against each other.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.
A spread is the difference in yield between two different types of fixed income securities with similar but not identical characteristics, with the possible differences including creditworthiness, maturity date, or other factors.
Investment-grade (IG) bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.
According to Moody’s Investor Services, debt obligations rated A are judged to be upper-medium grade and are subject to low credit risk. speculative characteristics. Obligations rated Ba are judged to be speculative and are subject to substantial credit risk. Obligations rated B are considered speculative and are subject to high credit risk.
Sovereign debt refers to bonds issued by a national government in a foreign currency, in order to finance the issuing country's growth. Sovereign debt is generally a riskier investment when it comes from a developing country, and a safer investment when it comes from a developed country.
Sovereign spread refers to differences in yields between sovereign bonds in different markets.
The Great Recession, also known as the financial crisis of 2007–08, the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.
The bid/ask spread, or bid/offer spread is the amount by which the ask price exceeds the bid; it is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
In finance, tenor refers to the time-to-maturity of a loan or other financial contract. The term tenor is most commonly used for non-standardized contracts such as interest rate swaps, whereas the term (remaining) maturity is used for standardized instruments like bonds.
The JPMorgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds, and local market instruments.
The JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad is a global, liquid corporate emerging markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging markets entities.
The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging market governments
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
Beta measures the sensitivity of an investment to the movement of its benchmark. Lower-beta refers to securities with low volatility in comparison to its benchmark.
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything.
An interest rate swap (IRS) is a swap based on interest rate differentials.
A credit default swap (CDS) is designed to transfer the credit exposure of fixed income products between parties.