Cyclical Considerations in Valuing Emerging Markets Debt

Abstract

Recent research suggests that emerging markets (EM) sovereign and high-yield (HY) corporate bonds with the same credit rating have similar creditworthiness in general and similar average default rates in particular. Consequently, all else equal, similarly rated sovereign and corporate bonds should trade at similar spreads over U.S. Treasuries. This article sets out to improve on the intuitive method of relying on ratings-adjusted spread differentials to determine relative value between the two asset classes. It argues that for any given credit rating, annual default rates of EM and HY bonds are closely linked to their respective macroeconomic cycles and thus deviate significantly from their long-term averages. As the EM and HY macro cycles are not necessarily synchronous, there may be situations in which similarly rated EM and HY bonds have different term structures of default and should therefore trade at very different spread levels. Given the recent outperformance of the EM macro cycle, incorporating a cyclical perspective into a relative value framework accentuates even more the persistent undervaluation of EM sovereigns. The lack of sufficient familiarity of most investors with EM most plausibly explains the undervaluation of EM relative to HY. As EM debt matures as an asset class, this lack of knowledge is likely to be rectified.