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

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

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

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.

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.