World’s riskiest emerging-market bonds in play as distressed makes a comeback

THE riskiest bond trade in emerging markets is mounting a comeback, offering double-digit returns to those brave enough to flirt with default.

A rebound in distressed government bonds is helping emerging-market US dollar debt to its best start since 2019. All but one of the 10 best-performing developing-economy bonds are in distress – from Bitcoin-touting El Salvador to pandemic-era defaulter Zambia, to serial bailout recipient Argentina.

The rally is, in part, due to prices recovering from rock-bottom levels last year, when traders were overly pessimistic about recovery expectations. But it is also a reflection of how investors pivoted towards riskier investments at the start of the year, driving up assets across financial markets.

While the shift in sentiment may turn out to be temporary, for now it is a welcome change for the small universe of buyers of distressed securities – a high-risk, high-reward trade in bonds that yield at least 10 percentage points above US Treasuries.

“Distressed countries are among those in the asset class with the most upside potential,” said Carl Ross, partner and sovereign credit analyst at Grantham, Mayo, Van Otterloo in Boston, which counts distressed Tunisian bonds among its top picks in emerging markets. 

Enticing returns

The payouts can be enticing: El Salvador bonds – this year’s best performer – were yielding more than 30 per cent at the start of 2023. Argentina’s dollar bonds due in 2029 currently trade at around 29 cents to the US dollar, more than 60 per cent higher than they did last summer. 

It was a drastically different scenario a year ago, when nearly two dozen developing countries were trading in distressed territory amid fears of widespread defaults and a global recession. Sri Lanka, sanctions-tangled Russia and Belarus last year tumbled into default, while Ukraine won support to delay payments. 

International bonds from Pakistan lost around half of their value in 2022 as investors grew concerned about non-payment. A Bloomberg gauge of emerging-market sovereign dollar bonds fell 17.4 per cent last year, the worst performance on record.

Risk repricing

The global economic picture has since improved, with the International Monetary Fund raising its growth forecast and predicting cooling inflation. Credit-default swaps showed that the risk of default has fallen to its lowest level since last February, before Russia’s invasion of Ukraine roiled markets worldwide.

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The change in sentiment has created an opening for distressed investors, who found value as prices for some defaulted bonds fell below the amount investors expected to receive in a debt restructuring. 

Money managers have invested US$4 billion in exchange-traded funds that track emerging markets this year, a large chunk of the US$8.7 billion that has flowed into the asset class, said JPMorgan Chase. Last week, they withdrew more than US$540 million, ending an 18-week streak of inflows that reached US$25.3 billion.

So far, emerging-market dollar bonds have returned roughly 1.8 per cent, their best start since 2019. That was largely driven by the rally in the lowest-rated debt, which was up almost 12 per cent, based on data compiled by Bloomberg.

Warning signs

The bullish outlook from distressed investors runs contrary to some recent calls on emerging markets. Citigroup strategists advised investors to cut their exposure until there was clarity on how high the Federal Reserve would raise interest rates, saying that the weaker-dollar consensus might prove wrong. 

JPMorgan Chase analysts said sovereign debt was “likely overbought and expensive”. And Man Group, the world’s biggest publicly-traded hedge fund, was betting on a rout.

Ecuador last week demonstrated how quickly risky trades can go south. Its bonds plunged after President Guillermo Lasso’s proposed constitutional changes were unexpectedly rejected by voters. Up until that point, the country was among the best performers in emerging markets. Now, it is the worst. 

But investors who have stuck with the trade see the strong start of 2023 continuing, helping them beat market returns. 

Picking winners

There are various reasons for optimism: El Salvador, which bondholders feared would default, made good on an US$800 million bond that was due last month. Ghana included its local bonds in negotiations with creditors, which should help make its debt load more manageable after a restructuring. And investors are increasingly confident that Argentina will soon have a change in government. 

It also helps that the crises inflicted by Covid and Russia’s war in Ukraine weeded out some of the weakest credits, making it easier to choose winners.  

“We have a better idea of which countries have the ability to cope. Therefore, assessing risk reward and value is easier now than in 2022 or 2021,” said Carmen Altenkirch, a London-based analyst at Aviva Investors. “The market is functioning better… in part due to a greater degree of certainty.” BLOOMBERG