A recent study from S&P Global caught our eye when it said: “Due to higher debt and an increase in borrowing costs on hard currency debt, we expect sovereigns will default more frequently on foreign currency debt over the next 10 years than they did in the past."
Ominous news, perhaps, for allocators which hold emerging market debt (which isn't everyone).
Sovereigns spent almost 20 per cent of their annual revenues on interest payments in the year before defaulting, the authors found, and these higher borrowing costs had resulted from rising inflation, exchange rate devaluation, and foreign currency borrowing.
Morningstar is one DFM which holds a material position here, but portfolio manager Mark Preskett informed us they sold the last of their hard currency bond exposure in their most recent rebalance at the start of Q3.
Instead he prefers local currency debt, which is “driven by the view that these bonds are offering the most attractive real yields”.
“This stands in stark contrast to core European and Japanese bond markets,” he said. “We also are attracted to relatively cheap currency valuations, particularly in Latin America.”
The two active funds Morningstar uses to gain this exposure are Barings Emerging Markets Local Debt and Colchester Emerging Markets.
Over at LGIM, multi-asset fund manager Andrzej Pioch is taking a similarly cautious approach.
"It's really important that you're spreading your risk again across those sovereign issuers, rather than taking bets on one or two of them," he said.
He added that they've traditionally had between 5 and 10 per cent in EMD across portfolios, so it’s usually a decent chunk of their overall credit exposure.
But because LGIM is so negative on investment grade credit at the moment, Pioch sees a degree of correlation within all credit classes, and so they are not taking as big of a bet as they used to.
“Credit to us is still oddly priced, expensive, and not rewarding you for the risk that you take if anything goes wrong,” he said. “Credit spreads could still widen, and when you look at the spreads of 80 – sometimes even below 80 basis points – is this really the asset class that rewards you for the risk you take?”
More broadly, our most recent sentiment survey found a feeling of near-unanimous neutrality among DFMs – 88 per cent of whom had no strong feelings either way about the prospects for the asset class.
In our previous note on the topic, however, we chatted with You Asset Management, who told us local currency EMD was by far and away their preferred form of carry in the current environment. You can read more about that here.
