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I’m here to give you rope, one solid enough to convince you to dump your iShares J.P. Morgan USD Emerging Markets Bond ETF (NASDAQ:EMB) and similar positions at a loss. However, at a loss small enough to look back with exasperation on how much worse it could have been if you held on to dear life. EMB holds a significant portion of EM sovereign importers, both High Yield and Investment Grade. This, coupled with the historically terrible recovery values for EM sovereign debt, leads me to the conclusion that there could be a lot of downside to the fund holdings that haven’t been priced into the market.
Introduction
Emerging market debt in principle and EMB
Fixed Income are simple instruments. Some would say, by design. In general, they provide fixed cash flows and principal at maturity for some of your money at the start. The Emerging Market space is rife with many investment ‘opportunities’ for those who want higher yield. A look at a simple screen of USD Sovereigns issued on Bloomberg over time shows the past two years, issuances have been the highest they’ve ever been. These have largely been segmented into short duration (<2Y) and moderate duration (>5 years).
Likely, this has been due to the pandemic and the continuation of the Fed’s zero interest rate policy. A policy, mind you, that has been consistently thought, up until the last few months, to last at least until 2023 and a year ago until 2025. The impact of this, in essence, is that countries are going to have to roll over principal for the shorter-term debt and pay interest (with a spread between 100bps and 400 bps).
What’s different now is that the debt of EM countries is a lot larger, the USD is a lot stronger, and spreads may get significantly wider (they have been getting narrower with forward yields of US treasuries rising). This leads to my view that EM debt at higher yields are unsustainable and likely there will be defaults and refinancing in the near term as the Fed tries to normalize monetary policy to fight inflation.
What does EMB invest in?
EMB is one of the largest Emerging Market Hard Currency (HC) bond funds. EMB invests in Emerging Market Sovereign Bonds in many different countries. Their holdings are almost all in Sovereign Bonds denominated in USD or EUR. These countries issue these bonds in USD to obtain cheaper financing terms (as the USD rates are cheaper) and to open up their financing options to conservative investors. In return, investors in these HC bonds may get a better return on investment.
Figure 1: Country allocation of EMB to illustrate the country diversification in terms of market value of the holdings
Historical performance and portfolio assessment
The fund and the asset class itself (benchmark) has returned worse than the standard US high yield ETF, iShares iBoxx $ High Yield Corporate Bond ETF (HYG) (see Figure 2). This is in addition to higher volatility characteristics: EMB has a historical volatility of 11.76% vs HYG’s 8.34% (see Figure 3). This is not to mention the obvious glaring difference of EMB having a majority Investment Grade holdings. The only excuse EMB has for such bad performance is the higher average duration (Figure 3).
There isn’t much of a selling point for EM bond Bonds because of the fact that when countries default, there isn’t much recourse for investors to get back their money. Bankruptcy laws for developed markets tend to allow companies many resources to restructure and ensure bond holders don’t lose money, which improves recovery value. Sovereign bonds not only don’t have this feature, but historically have had a recovery value of <10% once you factor in increased duration effects.
Figure 2: Historical returns of EMB (Top) and HYG (bottom)
Figure 3: Portfolio Breakdowns of EMB (top) and HYG (bottom)
So far, I’ve painted a picture of a bad asset class and maybe a fund that may under perform. Ostensibly, these are still sovereigns that want/need access to financing, what could possibly be so bad for me to accept a loss if I’ve already held it?
Breaking down the credit grades
My thesis is a further repricing of risk in the EM space that would significantly impair many countries from being able to sustainably pay EMB sovereign holdings. This repricing, if it were to continue, would lead countries to the hard decision of choosing to pay inflated interest payments with their weaker currency or make the hard decisions of sand bagging investors.
Defaults would lead to a significant decrease in the present value of many of EMB’s bond holdings. The most important would be de-risking outflows out of the fund and the EM space in general. It wouldn’t need that many countries to default to force many other positions into disorderly liquidations and lead to a 30-40% decline in the fund value.
My rationale
Breakdown of issuers and composition of EMB and other similar ETFs
HC bonds are issued by a broad array of net exporters and net importers. A look at the weighted average of the country holdings of EMB shows that there’s a split between net energy/food importers and exporters. However, as usual, most of these countries have a sizable GDP component of food and energy (in sharp contrast to developed markets), as shown in Figure 4.
This leads to an outsized negative impact of inflation to these countries. Net Energy Exporters (i.e., Arab states and some South East Asian countries) may weather the storm and accept higher food prices with a massive current account surplus, as we’re already seeing with many of these energy exporters. However, most countries do not have this luxury. This could lead to a higher default rates and impairment of EMB’s NAV and their dividends.
A decline in dividends to 3% due to defaults would suggest a decline in NAV of ~20-32% from the portfolio duration assignment.
Let’s look at EMB more closely.
Food, Food, Food
I’ve constructed a table to see the holdings of EMB; for each country, I looked up the % of consumer expenditure spent on food. NA means no data, but this still means 55-68% of the countries have a food consumer expenditure above 20% in 2017 prices. This suggests a much higher food price will almost assuredly cause many of these bonds to enter distress territory or, more importantly, reflexively lead investors to dump positions which may instigate the problem to begin with.
The ones that are currently showing distress are Ghana (-27% discount to par), Sri Lanka (-55% discount to par), Lebanon (-88%), and Ethiopia (-22%). There are many other countries that may show distress (e.g., Indonesia, Iraq, Nigeria, Kenya, Egypt, Jordan, and India). India even made a deal with Russia, likely to avoid such a future catastrophe. If we use Ghana and Ethiopia discounts, then this suggests a 20-30% decline in present value.
Figure 4: Food Expenditure by EMB’s Country Holdings (sorted by select metrics)
Massive levels of issuance post GFC and, again, post COVID-19 crisis
Issuances of HC debt are also the highest they have ever been by EM countries, likely to weather the COVID storm and get back to sustainable growth. This would have likely worked as long as the USD stayed weak and the proceeds from the debt was used for long-term growth projects. We did not see this happening.
Why is this an issue? If the supply of HC bonds comes in rapidly on the USD weakening, it leads to the obvious end point of requiring growth (or further USD weakening), in order to sustainably roll over the debt. Debt is priced against its benchmark yields and spreads widen due to the repriced risk and supply/demand imbalances.
Therefore, EMB might decline in value from a dynamic of increased yields in the 10-30 year benchmark US treasuries and of course the outsized impact of spread widening. If yields go 2% in 1 year, the risk to this portfolio could be a decrease of 20-32% in value (duration 13.3 years).
Knowing that EM countries tend to be more Keynesian vs. supply side leads us to the conclusion that a weakening growth will do consistent damage to itself whenever the developed market countries have to tighten policy. Higher taxes and rates will cause the underlying issuers to potentially implode.
Talking about the currency further, as it relates to EMB’s credit quality and value before maturity, this leads us to an interesting observation.
EMB beta skew on the downside against USD strength, an issuance phenomena
EMB tends to have a stable beta on the way down and an unstable beta on the way up, with a running average of 0.5. I believe this is from the observation that as the USD weakens, issuances increase leading to a higher supply and better growth metrics in EM countries. When the USD weakens, capital inflows increase, debt issuance increase, and growth appears sustainable.
However, when the dollar strengthens, the opposite occurs but much more predictably. Leverage increases, future payments are going to rise, and imports become more expensive.
We can see this in Figure 5 where the beta between EMB and an EM currency index shows a higher beta when the currency goes down than when it goes up. EM currencies will likely weaken due to the impact of food imports getting more expensive which feeds into the current account. Only energy exporters will likely be spared from these effects, and they make up less than 30% of EMB.
Figure 5: Rolling weekly beta split between an emerging market currency index and EMB
How bad can this get?
Contingent upon a stronger dollar and sustained global inflation due to supply side issues (which will likely not wane in the near future), we could see significantly higher default rates in many EM sovereign bonds, many of which are in EMB’s…
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Read More: EMB: Emerging Into Crisis, Potential For Heavy Asymmetric Losses (NASDAQ:EMB)