Despite historically tight spreads and a record-breaking $56 billion in year-to-date issuance, the EM sovereign credit market has remained stable. This resilience, following a period of strong outperformance, suggests robust underlying investor demand. The market is absorbing the deluge of supply without significant spread widening, pointing to a constructive outlook and potential for further spread compression in lower-rated credits.
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Emerging market credit spreads are tightening while developed markets' are widening. This divergence is not a fundamental mispricing but is explained by unique, positive developments in specific sovereigns like post-election Argentina and bonds in Venezuela on hopes of restructuring.
Contrary to fears of being a crowded trade, EM fixed income is significantly under-owned by global asset allocators. Since 2012, EM local bonds have seen zero net inflows, while private credit AUM grew by $2 trillion from the same starting point. This suggests substantial room for future capital allocation into the asset class.
Despite strong year-to-date performance in what feels like a resilient market, seasoned EM sovereign credit investors are publicly emphasizing caution. They recognize that stretched valuations, described as a 'glass overflowing', and potential US recession risks create significant downside vulnerability.
The surge in emerging market sovereign debt isn't uniform. It's heavily influenced by specific situations, such as Mexico issuing massive debt to back its state oil company, Pemex. Additionally, a notable increase in issuance from lower-rated 'Single B' sovereigns indicates renewed market access for riskier credits.
Due to compressed credit spreads, investors are shifting their focus from sovereign bonds to local market opportunities like currency and local bonds. They perceive fewer opportunities in credit and are actively seeking value in countries like Nigeria, Egypt, and Kazakhstan, where local stories are more compelling.
While overall EM credit spreads are near post-GFC tights, making value scarce, Argentina stands out. Following positive legislative election results, its sovereign debt has rallied significantly but remains wide compared to its own history and peer countries, suggesting substantial room for further performance in an otherwise expensive market.
Contrary to a simple narrative of improved market sentiment, EM sovereign resilience stemmed from unexpectedly strong macro fundamentals. Better-than-forecast current account balances, export performance, FDI, and portfolio inflows were the primary drivers of stability, exceeding even conservative projections from two years prior.
Despite forecasting a massive surge in bond issuance to fund AI and M&A, Morgan Stanley expects credit spreads to widen only modestly. This is because high-quality, highly-rated companies will lead the issuance, and continued demand from yield-focused buyers should help anchor spreads.
Despite compressed spreads and improved market access, credit markets are not complacent. Pricing for the most vulnerable emerging market sovereigns still implies a significant 17% near-term and 40% five-year probability of default. This is well above historical averages, signaling lingering investor caution and skepticism about long-term stability.
Despite being at historically tight levels, EM sovereign credit spreads are unlikely to widen significantly from an EM-specific slowdown. The catalyst for a major sell-off would have to be a 'beta move' originating from a crisis in core US markets, such as equities or corporate credit, given the current strength of EM fundamentals.