Vanguard active fixed income
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By Nick Eisinger, emerging markets lead strategist, Vanguard Europe
As emerging market (EM) sovereigns confront ongoing macroeconomic and geopolitical risks as well as the tightening of global financial conditions and the threat of recession, this environment has increased the likelihood of countries facing debt restructuring. Amid these challenges, many investors are questioning whether now is the time to be concerned about restructurings and defaults in EMs and how they can navigate them.
Weathering the storm of the economic impact of Covid-19 put significant pressure on the public finances of many EM countries. Some oil-exporting emerging economies—which have benefitted from the recent rally in oil prices—have been able to manage their debt burdens more comfortably coming out of the pandemic. But sluggish growth across EMs, combined with spikes in inflation in both developed and emerging economies, is putting significant strain on many others.
On top of that, EMs are facing the sobering prospect of the end of the era of easy monetary policy in developed markets. In March, the US Federal Reserve (Fed) raised interest rates for the first time since 2018 in an effort to contain inflation, and market participants expect a series of further rate hikes by the Fed over the coming year and beyond.
Rising rates in developed markets have historically been bad news for EMs. For one, they drain investment flows from EMs. Capital tends to gravitate towards higher-yielding assets, so higher US rates typically encourage investors to sell non-US dollar-denominated assets and buy those denominated in “greenbacks”.
And rising developed market rates are especially bad news for EMs that are already struggling to manage their fiscal deficits, as higher rates make it harder and more expensive for distressed or near-distressed sovereigns to raise commercial funding.
Add to this the threat of recession—which could push Fed rates higher still—and it’s understandable why EM restructuring is a topical issue.
Several EM countries have already entered debt restructuring negotiations, while others are approaching this stage fast and their bonds are behaving as though they were officially “distressed”. As of 1 April, 16 countries in the J.P. Morgan EMBI Global Diversified Index could be classified as distressed (defined here as having bond spreads in excess of 1,000 basis points)1. This is a similar number to the 15 distressed sovereigns seen in April 2020, at the height of Covid-19 crisis. Nine of these 15 distressed countries remain so after two years; six have recovered, while seven newly distressed debtors have slipped into hard times since then.
EM distressed sovereigns – April 2020 and April 2022
Source: Vanguard, J.P. Morgan EMBI Global Diversified Index, as at 1 April 2020 and 1 April 2022.
The causes of distress can vary widely. For example, the bonds of Russia and Belarus are in distressed territory largely as a result of the international sanctions imposed on those countries following Russia’s invasion of Ukraine. The egregious effect of the war is also putting pressure on Ukraine’s ability (although not yet its willingness) to service its debt obligations.
Elsewhere, unorthodox economic policy has contributed to distress. For example, the sovereign bonds of El Salvador—where the government is pursuing domestic financial repression while attempting to develop non-traditional, cryptocurrency-based external funding sources to meet its upcoming financial obligations—also trade at distressed levels.
A number of EM countries—such as Ethiopia, Lebanon, Sri Lanka, Venezuela and Zambia—are already in default, and some of these are entering restructuring negotiations.
Other names, where pricing reflects a distressed situation but where bond coupons remain paid, could go on to avoid default. Ghana and Tunisia, for instance, thanks in part to their higher reliance on local debt markets and limited external bond repayments due this year and next, could well escape distressed territory. Pakistan—another stressed credit—could move clear of distressed levels, especially as its external funding need is lower than that of many of its peers.
While caution is warranted when it comes to distressed debt, there are many opportunities to find alpha. The critical element to successfully navigating these situations is judging the right price at which to buy distressed bonds. For many sovereigns which ultimately undergo debt restructuring, their restructured bonds will go on to be worth more than the distressed price their debt currently trades at.
The critical element to successfully navigating these situations is judging the right price at which to buy distressed bonds.
A crucial lifeline for many distressed sovereign issuers is IMF funding. Since the onset of the pandemic in 2020, the IMF has launched a number of financing initiatives targeting EM countries, including its Rapid Financing Instruments2, allocation of Special Drawing Rights and official debt reprofiling under its Common Debt Framework. A number of distressed situations in EMs—such as the cases of Ghana, Pakistan and Tunisia outlined above—stand to gain from IMF support.
China is also an increasingly important influence in EM debt restructuring. China has become a sizeable creditor to a range of less developed countries, especially in Africa, and it typically does not form part of official investor groups such as the Paris Club or Eurobond holder panels.
With numerous EMs facing restructuring, it’s important for investors to bear in mind that recovery values can vary depending on the value of debt outstanding relative to GDP, the type of bonds issued, creditor composition and the pace and effectiveness of structural reform. Many sovereigns retain access to some form of funding even if their debt levels are high and deteriorating, while governments are typically loath to alienate their commercial investor base. What’s more, defaults can take months, or even years, to play out, and investors tend to receive plenty of warning.
While defaults are often idiosyncratic, the latest round of distressed situations share some common risk factors, such as fiscal stress or external funding distress. Here, it helps to have a clear understanding of the potential impact of taking on exposure to concentrated and correlated risk factors in a portfolio.
The key to adding value from distressed borrowers is investing at the right price and the correct time in their credit cycle. In most cases, it’s important to gain exposure before an official debt moratorium3 is announced, as bond prices usually sell off well ahead of any actual announcement of default.
For our funds, distressed debt investment decisions are guided by fundamental research around restructuring scenarios and recovery values, alongside portfolio and risk management that seeks the best opportunities on the bond curve of the affected country.
Trade sizing and liquidity are also key aspects of our investment approach – whether the debt in question in distressed or not We seek to avoid concentrated and correlated positions and to manage downside risk, and our bottom-up focus on security selection and relative value can add consistent risk-adjusted alpha.
1 Source: Vanguard, J.P. Morgan. As at 1 April 2022.
2 Source: IMF. 1 March 2022. https://www.imf.org/en/About/Factsheets/Sheets/2016/08/02/19/55/Rapid-Financing-Instrument.
3 An official debt moratorium is similar to a default, although it implies a complete halt to all debt servicing while a default can in theory be implemented on a negotiated basis. Source: Vanguard.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds
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