Emerging Markets Debt Investors Brace for ‘Trump’s Downfall’

At first glance, 2017 could be a tricky year for emerging market corporate debt investors.

The growth program promised by new US President Donald Trump – based on tax cuts and infrastructure spending – raises the prospect of higher US interest rates, threatening to raise yields and lower fixed income asset prices.

If the prospect of a “Trump meltdown” alone weren’t enough, the fall in emerging market corporate debt yields in recent years – which has narrowed the spread over US Treasuries of denominated bonds in dollars to about 270 basis points from a cyclical high of 520 basis points a year ago — leaves plenty of room for a reversal.

“When people are nervous about rising interest rates, we tend to prefer sovereign security. [debt] than the company, which by definition will be less liquid and more inclined to sell,” says Stuart Culverhouse, head of research at Exotix Partners, an investment bank focused on emerging markets.

“We saw an eruption of [corporate] episode. Some of the less robust transmitters can fall off at the first opportunity. »

Jan Dehn, head of research at Ashmore, the emerging markets-focused asset manager, adds: “Emerging market companies don’t offer as attractive an opportunity as they did a year or two ago,” after 9.7% yields for dollar debt. last year, as measured by the JPMorgan CEMBI Broad Diversified Index.

Ashmore has significantly reduced its exposure to emerging market corporate debt over the past year and a half. The weighting of dollar-denominated corporate debt in the manager’s mixed debt strategy has fallen from over 30% to less than 10%.

However, there are reasons to be optimistic about the outlook for emerging market corporate papers.

Dehn points out that in terms of the fallout from rising inflation and interest rates in the United States, the market is already pricing in two or three rate hikes this year, so more rapid tightening is needed. to have an impact.

More broadly, Dehn is among those who believe the Trump administration will struggle to pass a so-called border adjustment tax, which is imposed on imports but not exports. If so, it could derail Mr. Trump’s tax hike plans, leaving him with less ammunition to fund fiscal stimulus, which could lead to lower-than-expected inflation and monetary tightening.

This scenario of lower inflation could further help emerging market debt by undermining support for a stronger dollar. In effect, a weaker US currency decreases the liabilities of foreign companies that have borrowed in dollars and potentially makes local currency debt more attractive to foreign buyers.

Victoria Harling, portfolio manager at Investec Asset Management, says that if inflation were to rise, emerging market corporate debt would fare better than most other fixed-income assets because it typically has a relatively short duration. .

The difference in economic growth between emerging and developed markets – about 2.6 percentage points in favor of emerging markets last year – is also expected to widen slightly this year, helping to boost interest for all emerging market assets.

Dehn expects the biggest opportunities to be found in local-currency-denominated emerging-markets corporate debt, an often overlooked category despite accounting for $8 billion of the $10.7 billion in the global asset class.

Debt in local currency yields 8.2%. A slight contraction in yields — combined with a 5% rise in emerging market currencies due to the reversal of the Trump dollar rally — could push total returns up to 16% this year, he says.

By contrast, Ms Harling describes local-currency corporate debt as a “very unattractive asset class”, given that while sovereigns can print money to service their debt, corporations cannot. not. The yield gap between the two is insufficient to compensate for this, she argues.

Ms Harling also considers high-yield dollar-denominated corporate debt – which currently yields 6.3% on average – to be expensive compared to investment-grade paper at 4.2%. This led Investec to reduce its exposure to the high-risk segment.

“Single-B [rated credits] are pretty much priced perfectly. They don’t foresee any downside risk,” she says, referring to Rusal, the Russian aluminum producer, which sold a five-year bond at a yield of 5.1% in January.

“I’ve seen this train crash a few times so we just pass it on and wait for it to be re-priced. It doesn’t look like it will be this year,” Ms Harling adds.

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Carol M. Barragan