Bloomberg Línea — The aggressive monetary policy of the world’s central banks, particularly the United States Federal Reserve, together with the adjustment in financial conditions and the consequent strengthening of the dollar, have led to an increase in the yields of sovereign and corporate bonds, causing investors to suffer losses of a magnitude similar to those observed during the greatest financial crisis of this century.
This scenario has dragged down emerging market bonds, including those of several Latin American countries, generating large losses in the fixed income sector.
Although emerging markets have shown a certain resilience, for example in terms of the performance of their currencies, they could not escape a year that has been very bad for most assets.
Emerging markets fall more than in 2008
To get an idea of the magnitude of the losses, a report by the Argentine broker Balanz Capital says the situation “has no parallel, even with what was evidenced during the 2008 global crisis”.
In that year, the Bloomberg emerging markets fixed income index in dollars saw a drop of 14.8%, while so far in 2022 (to October 17), the decline is more than 21%.
Even when broken down by credit level, it can be seen that “investment grade” emerging market bonds (i.e. those with the best perceived quality) have suffered the worst fall since the index has been in existence in 1997.
The situation is not limited to emerging markets, however: US fixed income (according to the US Aggregate index) has fallen by more than 15% in 2022, the sharpest drop since 1973, when it began to be measured, according to Balanz Capital.
“So far this year, emerging market bonds have been among the hardest hit assets as a direct reaction to the global macroeconomic context,” Lucas Buscaglia, fixed income and macroeconomics analyst at IOL invertironline, explained to Bloomberg Línea.
“To date, the emerging bond ETF (exchange-traded fund), JP Morgan’s EMB, has registered a drop of more than 28%, making it the worst year for this index since its creation in 2007,″ he added.
Buscaglia explained that this ETF marks what the trend has been, and that the deterioration “has been mainly due to the rate-hike cycle initiated by the US Federal Reserve”.
“The rate hikes have not only caused credit to become more expensive, but also generated a significant rise in the dollar (measured by the DXY index), and a worsening of the outlook for growth, a situation that ended up directly affecting emerging markets,” Buscaglia said.
To put in context what international financial assets have been suffering, so far in 2022 the S&P 500 of the NYSE has fallen by nearly 23%, while the Nasdaq has already fallen by more than 32%.
Could this lead to debt roll-over problems?
Diego Ferro, who leads the M2M Capital fund on Wall Street, explained to Bloomberg Línea that “when people who follow bonds in the United States look at the sector, they do not see that it is a particularly bad year for emerging markets” given that “all the fixed income indexes did very badly”.
When asked whether this could cause problems for Latin American states and companies that need to renew debt in the medium term, Ferro said: “in general, highly indebted countries are in trouble. But since commodities are relatively strong, many countries have the resources to face this situation”.
He also pointed out that many countries have the possibility of financing themselves in local currency, and that “central banks have maintained a fairly good anti-inflationary policy”.
Ferro considers that the situation of emerging countries “is not bad”, although “this does not mean that the current situation does not affect their financing.”.
“The International Monetary Fund is aware of the problem, and is working with some countries to avoid balance of payments problems,” he said.
On the other hand, he added that the difficult moment for bond prices does not seem to represent a systemic problem for emerging countries, unless the problem extends over a longer period of time. “It may be a problem, specifically, for countries that have been doing things badly”, he said.
For his part, Norberto Sosa, director of Grupo IEB, foresees a complicated 2023 for the credit market.
“The monetary tightening [cycles] that most central banks are executing are generating a recessionary context for next year. From the point of view of emerging countries, it will be more complicated to improve their fiscal results and commodity prices are likely to fall, at least in general terms,” Sosa said.
In the face of this recessionary context, Sosa foresees that an eventual complication in fiscal results could jeopardize the debt roll-over of some countries.
Causes of the scenario, and when a recovery may come
At the beginning of the year, the US monetary policy rate was in the 0-0.25% range, while hikes have pushed the interest rate to 3-3.25% in order to curb high inflation.
This situation has hit the markets in general and practically no index has been spared from the fall. In addition, the Fed’s policy rate is expected to be at 4.25-4.50% by the end of 2022.
“According to the Chicago Mercantile Exchange’s Fed Watch Tool, the market has already further discounted a 25-basis-point hike at the Fed’s February 2023 Federal Open Market Committee meeting, and that that 4.50/4.75 rate range level would remain until December of next year. Therefore, it is likely that part of the debt has already touched the floor, especially short-duration, high-credit quality debt,” Sosa said.
Sosa added however that, in addition to the phenomena of rising rates and a strong dollar, there are also geopolitical tensions.
“The Russian invasion of Ukraine generates risks in Eastern European countries, frictions between China and Taiwan generate risks in some Asian countries. Therefore, until we see spread compression in high credit quality debt, it is difficult to see a significant recovery in emerging debt.”
What to take into account when managing a debt portfolio?
Norberto Sosa pointed out that, when managing a debt portfolio, three major risks, among others, must be taken into account: duration, currency and credit.
“2022 has been a year in which the greatest risk was duration, which is why long US Treasury bonds fell, as did the Nasdaq 100. For those bonds issued in currencies other than US dollars, the falls were enhanced,” Sosa said.
Better than some developed economies
Nevertheless, even in the context of a very sharp fall, as described above, emerging bonds have been performing less badly than those of some developed countries. For example, the ETF composed of 100% UK government bonds is down 26% so far this year.
However, the situation is mixed: for example, the SDEU ETF, composed of German sovereign bonds, has fallen “only” 11% so far this year.
Resilience of emerging currencies
An article published in recent days by Bloomberg highlights that the relative resilience of emerging markets relative to developed nations has begun to attract the attention of money managers.
The report notes that the emerging market exchange rate benchmark has half the losses of developed markets. And it argues that the trend continues even with the fall in commodity prices, which are key to the economies of these countries.
The article notes that the success of developing countries in weathering some of the volatility linked to the Fed’s monetary tightening casts doubt on the assumption that they will be the epicenter of any market collapse driven by rising US yields.
“In reality, much of the pain is being felt in the UK and Europe, while countries such as Brazil and Mexico are seeing their currencies entice investors with juicy yields resulting from some of the world’s most aggressive rate hikes,” according to the Bloomberg article.