Emerging-market debt turns the corner

Read this article to understand:

• Why emerging-market nations and policymakers were in an upbeat mood at the recent IMF meetings.
• How political necessity has been forcing EM countries to get debt onto a sustainable path.
• Why policymakers are suddenly embracing the need for change and reform

Recent years have witnessed a sharp rise in yields across the emerging-market debt universe. This is partly explained by weaker developed government bond markets as the US Federal Reserve and other leading central banks hiked interest rates aggressively to try to bring inflation under control.

But emerging markets’ woes were compounded by concern over several countries’ debt trajectories and capacity to refinance debt in the aftermath of the COVID-19 pandemic and the war in Ukraine.

However, the past year has witnessed signs that many countries are starting to take more decisive policy action to address the economic challenges that had built up since 2020.

Against this backdrop, Aviva Investors’ emerging-market debt analyst Carmen Altenkirch recently travelled to Washington for the semi-annual meetings of the International Monetary Fund (IMF) and the World Bank. She spent the week engaging with policymakers and other officials and found them in a surprisingly upbeat mood, bolstering her belief many countries are willing to make the tough economic choices necessary to get their finances on a surer footing.

Despite a renewed rise in developed-market government bond yields since the start of 2024, Altenkirch sensed growing optimism that many countries have begun to turn a corner and that the risk of further defaults has receded, as she explains in this Q&A.

What were the key messages to come out of your meetings at the IMF/World Bank summit?

Recent years have seen the tradable universe within the higher-yielding segment of the EM debt market shrinking appreciably as several countries defaulted and even more lost the ability to refinance debt via capital markets. At the same time, there was a widespread reluctance to approach the IMF for assistance.

This meant a year ago there were very few countries that either looked in a decent place from a fundamental economic perspective, or where we thought there was sufficient prospect of a turnaround to make their bonds look attractive. As an investor, our opportunity set within the high-yield space was severely restricted.

But at the meetings in Washington there was a palpable sense that a growing number of countries have turned a corner or are in the process of doing so. What was striking at many of the meetings I attended was just how many policymakers acknowledged the need for change and reform.

In some cases, this was down to politicians’ acceptance that teetering on the edge of economic disaster will not do their chances of re-election any good. For example, we have seen a notable shift in Ecuador, which has now successfully agreed an IMF programme. President Daniel Noboa and his advisers tacitly acknowledged that without IMF support and reforms, their re-election prospects come May 2025 would likely be bleak.

In other cases, most obviously Turkey, elections in 2023 have already led to more orthodox economic policies being adopted. It is a similar story in Argentina. The country was complimented by IMF officials for its commitment to fiscal prudence as Luis Andrés Caputo, the economy minister, said the country had no option other than to live within its means.

A number of other nations similarly concluded they needed IMF support and are prepared to take the necessary reforms to secure it. In Pakistan, for example, with elections out of the way, politicians have begun to adopt a more pragmatic attitude towards seeking IMF support. Only four weeks into his job, finance minister Muhammad Aurangzeb spoke about the need for an IMF programme and the importance of raising revenue. Gabon and Senegal are likely to be next.

Six months ago, high-yield issuers were finding themselves locked out of capital markets. Is this still the case?

No, more and more countries have been able to access capital markets. This was the other main positive message I took from Washington. At the previous IMF meetings in October there was much uncertainty as to whether high-yield borrowers would be able or even willing to issue debt at penal yields. Without market access, the risk was of another wave of defaults.

However, since then increased risk appetite among investors has driven yields down to around ten per cent. In the past, if a country were issuing at ten per cent, that would have sparked concern its debt position was not sustainable.

But perhaps because we have seen such a big rise in US government bond yields, it now appears to be a level at which governments are prepared to borrow and investors willing to lend. This is especially true of countries which have shown over the past year or two they were able to consolidate budget deficits and rebuild reserves.

Initially, it was only the most economically resilient high-yield countries that were able to come to market, but more recently Ivory Coast, Benin, El Salvador and Kenya have sold bonds.

This time last year, there was a real risk of Kenya defaulting had it not been able to access the market. The fact it has been able to sell debt has enabled it to pay off maturing bonds and raise a small amount of additional financing. This, in conjunction with fiscal consolidation, means it is on a much more sustainable path.

Senegal is likely to be next, with its new government seemingly committed to reform in order to receive IMF support. It could be followed by Nigeria.

So have default risks abated entirely?

No. It is true that those countries which were most at risk have already defaulted.

Of the next tier of countries, some, such as Kenya, have been able to regain market access while Ecuador, Egypt and Pakistan have approached the IMF.

But others have yet to make much progress on negotiations to restructure their debt. While Zambia’s restructuring is largely completed, Sri Lanka’s and Ghana’s still appear some way off, amid a dispute with creditors over the terms of any bailout.

Bondholders believe the IMF is being too conservative in terms of its debt sustainability assessment and are pushing for a way to benefit should economic outcomes be better than assumed. For its part, the IMF, along with official creditors, does not want to saddle vulnerable countries with an uncertain repayment profile. It remains to be seen how this is resolved.

While the situation for high-yield countries overall has improved, meaning another bout of defaults looks unlikely for now, many remain extremely vulnerable. Arguably the biggest threat would be if the recent sell-off in US Treasuries were to persist.

The yield differential between emerging-market debt and US Treasuries has narrowed appreciably for good reason. Whereas markets used to consider US Treasury yields as a risk-free rate against which other assets were to be judged, it is questionable just how risk-free Treasuries are given the US’s dire fiscal position.

Then again, if necessary, the Fed has the option to embark on a new round of bond purchases, unlike its counterparts in emerging-market countries. Given the extent to which distressed bonds have already risen this year, much of this improvement in sentiment I witnessed at the IMF has arguably been priced in. It is debatable whether there is much room for spreads to tighten further. That suggests emerging-market nations will need to continue making progress getting their deficits into a sustainable position for bond prices to rally further.

Nonetheless, my trip reinforced my belief that in the event markets suffer a renewed sell-off, a larger cohort of countries will be able to withstand the pain, meaning investors suddenly have an expanded set of opportunities to choose from.