EM credit’s stress test

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There is no need for panic. Emerging market credit is outperforming US high yield and the investor base is stable.

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Whichever asset class you look at these days, the loudest voices are from the bears, the super-bears and the just plain hysterical. Once you start to see bubbles forming from all the recent monetary stimulus – and clearly asset prices have been inflated by developed economies’ central banks – it’s hard not to see them everywhere. And then to expect a huge pop with only a vertiginous downside.

Take EM credit. Huge liquidity has been pumped into the market since 2009 and, at its height, the risk premium of some deals certainly left Euromoney scratching its head. 

That peak has passed and markets are repricing. Yields have jumped. CDS on some credits – yes, you, Venezuela – all but price in defaults, while primary issuance has collapsed.

But, as yet, there has been no capitulation. Speak to investors, bankers or rating agencies and you find a remarkable level of confidence that, despite the background din of panic, the market is performing how it should, and how they hoped. Sovereigns have funded (mostly) in local currency and have large FX reserves. They’ll be fine (obvious outliers excepted). 

Unless the quasi-state companies implode. Here, there is greater risk and Petrobras is a case alone given the political paralysis, corruption and overly-optimistic growth ambitions. But while there are warning lights, the sirens to abandon ship aren’t blaring. Petrobras will almost certainly need some level of government support in 2017 but shouldn’t dangerously weaken Brazil given its otherwise low level of foreign debt.

No, this time in EM credit it’s the corporates that could trigger 'capitulation’. But, early in the downswing of the cycle though we are, the asset class is holding up remarkably well.

Bankers say we should credit the investors who pulled away from the weaker corporate paper that was brought to them at the top of the market. Investors say the currency effect is more nuanced than often assumed – most that funded in dollars have clients that pay in dollars.

Most of these companies appear to have been hedging where appropriate and disciplined about not gorging too fully before the subsidized dollar punch bowl was taken away. Also, as the dollar surge looks to be running out of steam, oil and other commodities shouldn’t be so depressed for too much longer. And that depressed primary issuance? See that as simple rebalancing, not a lead indicator of severe stress to come.

Of course it is too soon to say for sure – and there will be surprise defaults – but EM credit is performing better than US high yield. Investors report capital inflows (as well as some, admittedly, reporting redemptions). Stability is helped by the fact that EM debt’s juicy coupons mean investors would need to be pretty sure of the super-bear scenario to allocate into G7 debt at negative rates. 

Local currency bonds have been poor investments over the last couple of years (for dollar based investors) but the turning point could be in sight. In short, the investor base is likely to hold up.