Executive Summary
As we enter the final quarter of 2021, our valuation metrics for emerging external and local debt are moderately more attractive than they were at the beginning of the quarter:
- External debt valuations continue to remain within the historical range that we consider broadly neutral.
- Within local debt, emerging market (EM) currencies continue to remain at attractive levels having stayed through the quarter at the very top of the neutral range, while real interest rate differentials between EM and developed markets (DM) have continued to widen.
In this piece, we update our valuation charts and commentary, with additional detail on our methodology available upon request.1
External Debt Valuation
The EMBIG-D benchmark spread widened by 17 bps in Q3, ending the quarter at 357 bps. As seen in Exhibit 1, the fair market multiple is the benchmark’s credit spread to the spread that would be required to compensate for credit losses. This ratio rose marginally over the course of the quarter. The multiple stood at 2.5 on September 30, 2021, up from 2.4 on June 30, 2021. We estimate the credit multiple threshold range by analyzing the relationship between the subsequent two-year EMBIG-D credit spread returns and the credit multiple historically. A level that is higher than the upper range of the threshold (currently 2.8) has historically been associated with positive credit returns, while a level below the lower range of the threshold (currently 2.0) is associated more with negative credit returns over the next two-year period. This threshold range estimate is recalibrated on an annual basis. A level within this range would be considered neutral, which is where the market valuation falls at the end of the quarter.
Credit spread widening was the main reason for the small increase in the multiple over the quarter, as the multiple’s denominator – the fair value spread or expected credit loss – fell by only 1 bp to 142 bps at the end of September. Regular readers will recall that this fair value spread is a function of the weighted-average credit rating of the benchmark, along with historical sovereign credit transition data and an assumption about recovery values given default. In terms of the third quarter, the fair value spread was influenced by a couple of downgrades including Kuwait (AA- to A+ in July) and Ethiopia (B- to CCC+ in September). Additionally, while Panama, Sri Lanka, Peru, and El Salvador were placed on Negative Outlook, Jamaica was placed on Stable Outlook, and Oman was placed on Positive Outlook.
The preceding was a discussion of the level of spreads, or credit cushion. From a total return standpoint, the level and changes of the underlying risk-free rate also matters. In the third quarter, U.S. Treasury yields were basically unchanged, with the 10-year yield rising by 2 bps and having little impact on benchmark returns. We measure the “cushion” (which we proxy as the slope of the forward curve) in Treasuries by the slope of the forward curve of the 10-year swap rate, depicted by the light-font lines in Exhibit 2. As long-end U.S. Treasury yields were essentially unchanged during the quarter, the same was true for the slope of the 10-year forward curve; however, while the slope ended the quarter at 47 bps, the same level as the prior quarter, the entire curve shifted higher by about 15 bps, likely reflecting anticipation of a reduction in Fed bond purchases and impending rate hikes. This indicates the market is pricing in more of a cushion for rising rates, as the forward curve represents the path that would make an investor indifferent to holding treasuries and cash. We would view this as a positive relative to the previous quarter.
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