With a series of shocks hitting the emerging-market sovereign bond universe in recent years, investors need to be alert to the danger individual countries’ debt is being placed in the wrong risk bucket and mispriced, argues Carmen Altenkirch.
Read this article to understand:
- Why credit ratings often offer limited insight into near-term default and liquidity risks in emerging-market debt
- Why investors should look more closely to solvency and liquidity metrics to assess default risk and mispricings
- How we use our proprietary framework to identify risks and opportunities
The world’s poorer nations have been hit with several shocks in recent years, which in many cases have stressed government balance sheets at a time when central banks have been forced to hike interest rates sharply to combat inflation.
Amid growing investor caution, the combination of rising interest rates and larger funding requirements has been pushing a growing number of countries into, or towards, default, as they struggle to access private debt markets.
While the emerging-market debt universe has always been relatively heterogenous, it is more important than ever to pay close attention to individual countries’ relative positions. To understand why, one only needs consider the diverse nature of recent shocks. Eastern Europe has been disproportionately impacted by the war in Ukraine, Latin America has seen a shift to the left and increased political risk, while sub-Saharan Africa has been plagued by soaring food prices and a lack of access to capital markets.
At the same time, the outlook for many countries in the Gulf Cooperation Council has dramatically improved due to higher oil prices, while the economies of countries within the Commonwealth of Independent States have been helped by an influx of Russian capital.
The problem with ratings
Investors typically use credit ratings to assess a country’s risk of default. The problem is that these ratings place significant emphasis on structural factors like per-capita income, an economy’s size and governance. Since these factors only change slowly, they offer limited insight into the near-term risk of default and liquidity challenges.
Figure 1 illustrates the potential pitfalls in being overly reliant on credit ratings. It plots different countries’ ratings against a proprietary index we created to rank countries by risk of default. We use the same metrics as the International Monetary Fund's (IMF) debt sustainability analysis: namely government debt-to-GDP ratios to assess solvency and structural liquidity issues, either because a country does not generate enough dollars through exports or because its debt-service payments are unsustainable.
Figure 1: Credit ratings too broad to isolate default risk
Source, Aviva Investors, March 2023
Ranking countries in this way does not capture countries’ willingness to pay, course correct by going to the IMF, or access to other pools of capital. Nonetheless, it can help us consider where and why there may be mismatches between how a country is rated and our assessment of its default risk.
Predicting which country is likely to fall next is not all about default risk. Investors also need to consider which countries are more vulnerable to external shocks than their ratings would suggest. It appears in some cases investors need to be better compensated for the risk they are taking than ratings would suggest.
Hungary, Romania and Colombia are three countries that stand out as having higher risk then their rating implies
Hungary, Romania and Colombia are three countries that stand out as having higher risk then their rating implies. In the case of Hungary and Romania, membership of the European Union would be a significant qualitative support for the rating, which is helping to mask a deterioration in insolvency metrics. As for Colombia, past policy credibility has helped support the country’s rating in the face of a series of vulnerabilities. The same is true of South Africa.
On the flip side, the strength of various financial metrics and improvement in economic performance is arguably not fully reflected in the ratings of certain countries such as Azerbaijan.
Nigeria is another country whose credit rating is arguably too low, perhaps due to fears the country’s new government will not devalue the currency and/or be unable or unwilling to improve fiscal sustainability by cutting subsidies or implementing some basic reforms to boost revenue.
Moody’s assigns the country’s debt a lowly triple-C rating and credit default swaps imply a 50 per cent chance of default over the next five years. However, our analysis suggests a much lower risk of default, driven by low debt levels and reasonable reserves relative to external debt payments.
Using a different lens
In the current stressed environment, investors would be wise to take a close look at solvency and liquidity metrics, and not simply rely on official ratings. In Figure 2 we use the same default index and introduce a liquidity metric, to better assess near-term strains from a liquidity perspective.
Figure 2: Assessing the risk of distress
Source, Aviva Investors, March 2023
With liquidity stresses more prevalent and solvency concerns higher, considering liquidity and default risk together provides a useful lens through which to assess those countries at most risk: either of material spread widening or, in the extreme, of default and the need to restructure debt, should they face further shocks or if market access becomes impaired.
In the past, balance of payments or liquidity issues were dealt with via IMF programmes. However, countries are increasingly running into the limit of how much they can borrow. Where IMF funding is available, governments might be reluctant to push ahead with unpopular reforms in an era defined by mounting social unrest.
A greater weight is attached to countries with high government financing requirements
We assess near-term liquidity needs by considering a country’s external financing requirements as a proportion of its international reserves. A greater weight is attached to those with high government financing requirements.
The area shaded red contains three countries (Sri Lanka, Zambia and Ghana) that have already defaulted. The first two had metrics that clearly indicated high default risk aggravated by severe near-term liquidity challenges. In Ghana’s case, it had a similar default risk but opted to default before liquidity stresses became extreme.
As for other nations in this danger zone, Egypt, Pakistan and Tunisia screen as having high default and liquidity risk and require sizeable near-term liquidity relief to avoid default. But while El Salvador and Kenya fall into this category too, they do not look in imminent danger of severe stress as neither country has Eurobonds maturing this year. That said, both will require market access, significant fiscal consolidation and sizeable liquidity support to avoid having to restructure their debt within the next three to four years.
While not currently in the danger zone, Turkey faces severe liquidity risks due to low net reserves and high financing requirements, particularly from the private sector. While the country’s low debt level means it is solvent, the authorities will be under pressure to strengthen the external liquidity position following elections in May. Otherwise, the risk of debt distress is likely to rise significantly.
Our framework reveals Colombia, Hungary, and Romania have become more vulnerable to further shocks
This framework can be used to consider how rankings have changed within the broader EM sovereign high-yield universe due to various shocks in the past three years. It reveals Colombia, Hungary and Romania have become more vulnerable to further shocks, while Ivory Coast, Serbia, Paraguay and Azerbaijan have emerged relatively stronger.
Recent weeks have highlighted how quickly market sentiment can turn as investors focus on vulnerabilities, especially solvency and liquidity concerns. In just two months, , the value of Egyptian government debt has plunged by nearly 20 per cent. If liquidity stresses continue to build, we estimate bonds could have significantly further to fall given anticipated recovery values of around 50 cents on the dollar in the event of default. Kenya bonds also appear at risk of a material decline in price. The African country could be about to secure new financing of as much as $2.5 billion, shortly. However, while this would tide it over in the short term, bond prices will be at risk of further declines if reserves continue to fall.
Figure 3: Assessing default risk
Source, Aviva Investors, March 2023
Frequently reframing the EMD universe along different dimensions to identify potential cracks and opportunities, and not simply relying on official credit ratings, is key to protecting capital but also identifying alpha opportunities.
Reducing exposure to countries where risk is under-appreciated is part of the process. But equally, investors should look to take advantage of attractive yields that are being overlooked in times of market stress.