Emerging Markets: Improvement Arrives, but for How Long?

Emerging markets bounced back in the first quarter after three years of torpor but the deteriorating credit quality for many government and corporate borrowers signals possible trouble ahead

By Carolyn Cui

Brazil’s real has gained 9% against the dollar so far this year.

Brazil’s real has gained 9% against the dollar so far this year. Photo: Dado Galdieri/Bloomberg News

Emerging markets bounced back in the first quarter after three years of torpor but the deteriorating credit quality for many government and corporate borrowers signals possible trouble ahead.

Monetary easing by major central banks, as well as a firming of oil prices and other commodities during much of the quarter, powered emerging-market stocks and bonds higher.

Brazil, Turkey and Mexico led the way, with their main stock indexes on pace to climb 18%, 16% and 7%, respectively, in the quarter, compared with a 1% gain for the S&P 500.

Currencies also gained ground against the dollar, with the Brazilian real and Russian ruble gaining 9% and 5.8%, respectively, in the year to date.

Credit-rating firms, however, have been looking beyond the recent emerging-markets rally at more ominous signs for developing countries: weaker global growth, commodity prices that remain well off their recent peaks and the prospect of a stronger dollar that would raise the cost of repaying dollar-denominated debt.

The economic backdrop has led credit agencies to cut ratings on emerging-market dollar-denominated bonds to their lowest level in more than six years. Downgraded in the quarter was the sovereign debt of more than 10 emerging-market countries including Azerbaijan, Bahrain and Poland. Debt from South Africa and Saudi Arabia was put under review for possible downgrades.

The J.P. Morgan Emerging Markets Bond Index Global Diversified, the mostly frequently used index, has recently slipped below investment grade based on ratings of Standard & Poor’s and Fitch Ratings, according to the bank.

“I think we’re going to see a period of balance-sheet deterioration across emerging markets,” said Rashique Rahman, head of emerging markets at Invesco, which oversees $4 billion of emerging-market bonds. “We’re at the early stage of that.”

Lower credit quality indicates a higher probability of default. A recent J.P. Morgan Chase survey of clients showed that nearly half of the respondents expected the default rate among speculative-grade emerging-market corporate issuers to exceed 5% in 2016, well above the bank’s forecast at 3.5%.

Some investors say the rating actions may exaggerate default risk. Many emerging countries have ended their currency pegs to the dollar, built up foreign reserves and issued more debt in their own currencies, making them less vulnerable to the dollar’s strength.

“Given the weakness we have seen in commodity prices and the strength in the dollar, the fact that we haven’t seen a spike in default rate is probably an indication that emerging economies are stronger than people thought,” said Luca Paolini, chief strategist at Pictet Asset Management, which has $185 billion of assets under management. “Downgrades often come at the end of market declines.”

Still, rating actions can have a bigger impact on emerging-market bonds than on debt from Europe and the U.S. because other reliable information in the developing world can be harder to come by.

A slip into junk territory can also trigger forced selling from big investors like public pension funds and insurance companies, which often have guidelines mandating that a certain percentage of their holdings have an investment-grade rating.

Brazilian debt was among the latest downgrade victims after falling below investment grade. Fitch Ratings cut the sovereign to junk status on Dec. 16, which followed a similar move by Standard & Poor’s. Brazil’s government bonds lost 4% in price that day, according to MarketAxess.

The downgrade led to the exclusion of Brazilian bonds from the investment-grade bond indexes of Barclays BCS -0.29 % PLC, causing forced selling of about $5.2 billion for Brazilian government bonds, while high-yield funds bought only $1.4 billion of these bonds, according to Barclays estimates. Brazilian bonds made back some of those losses during the first quarter but remain below pre-downgrade levels.

Azerbaijan, an exporter of oil and copper, lost its investment-grade ratings from all three agencies during the quarter. Its currency, the manat, weakened 2% against the dollar, while its government bonds edged up 0.8% in price.

Emerging-market crises struck frequently in the 1990s, when massive capital outflows forced Mexico, Thailand and Russia to end their currency pegs to the dollar, leading to a wave of corporate defaults on dollar-denominated debt.

Debt has ballooned again in recent years. Emerging-market dollar-bond issuance is up by more than 50% since 2008 to about $1.9 trillion, according to the Bank for International Settlements.

More rating cuts are expected to hit emerging markets in the coming months: 31.4% of issuers rated by S&P in developing countries currently have a negative outlook or are on the watch list for potential downgrades, the highest level in more than six years. Many of the borrowers are in Brazil and Russia.

Dedicated emerging-market managers are allowed to hold both investment grade and junk bonds, but prices of the bonds are susceptible to forced selling. Mr. Rahman of Invesco said he is looking for either high-quality bonds or “deep-value opportunities.”

“It’s hard to be in the middle, where you’re seeing still some stuff gravitating toward subinvestment grade,” said Mr. Rahman.

Some long-term institutional investors say they are betting on emerging-market debt despite the uncertainty. The Connecticut Retirement Plans and Trust Funds allocate 4.8% of their $27.9 billion under management to emerging-market bonds.

“We believe emerging-market economies have the capacity to grow, and that as the economies mature, credit quality ratings will likely improve,” said David Barrett, communications director to the office of Connecticut State Treasurer Denise Nappier.

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