Over the past decade, the average credit quality of emerging-market (EM) investment-grade (IG) bonds and US IG corporate bonds have converged to an unprecedented extent. Why? And what does it mean for investors?
The EM ratings landscape looks different today than it did in 2006. Economic growth in many EM countries has helped significantly expand the IG playing field, which today has more EM issuers—both companies and countries—than ever. Colombia, Peru and the Philippines are a few sovereigns that were bestowed with the IG mantel in the not-too-distant past.
Fallen Angels Provide Lift
On the flip side, EM countries have not been immune to volatility in recent years. Deteriorating fundamentals, political turmoil and geopolitical stresses have gripped countries like Russia and Brazil. Many of the countries’ biggest companies were downgraded, such as Petrobras in Brazil and a slew of Russian banks, resulting in the loss of their IG status.
Similarly, on the sovereign side, some of the largest fallen angels have included Russia’s and Brazil’s debt. These countries had maintained a large presence in EM indices, and when their downgrades relegated them to junk status, the effect on the IG indices was noticeable.
The indices the fallen angels were forced to vacate now have much higher-rated bonds that, for the first time, are converging with US IG corporate bonds (Display). And as the lower-rated companies have moved into high yield, the overall credit-quality averages of the EM IG indices have improved.
The average rating of the US IG corporate bond index, on the other hand, has moved lower, especially as some companies within the basic materials and energy sectors have been downgraded to borderline IG.
But in the EM space, many companies in the energy sector are fully or majority-owned by the government—support that helped cushion the impact when their ratings were being evaluated. Additionally, the local producers in these industries have been helped by local-currency depreciation in maintaining competitive cost positions.
Implications for the Future
The rating convergence of EM IG indices with the US IG index is uncharted territory for the market. With some of the riskier names gone from the EM indices, the convergence of higher-rated EM and lower-rated US IG bonds means investors may not get the relative yield advantage they’ve earned historically as the market adjusts and relative yields decline to US levels.
As a result, investors will likely find that historical relative-value comparisons and top-down analyses no longer serve as helpful guides when comparing the two IG markets. To choose wisely and to know what risks you’re taking on, the best approach is to take a closer look at each investment—no matter where it’s grown.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.