Executive Summary
A rising global interest rate environment is once again leading to volatility in the emerging debt markets. Year-to-date through May 31, as the US Treasury 10-year yield has risen to the 3% neighborhood, the EMBIG benchmark of sovereign hard currency bonds is down 4.3%, and the GBI-EMGD benchmark of local currency sovereign debt is down 3.7%. In a piece I wrote in June of 2015 on the eve of the Fed’s long-awaited tightening cycle, I highlighted several reasons why the emerging debt markets should not panic at the Fed’s monetary policy normalization.1 And, while the EMBIG returned only 1.2% in 2015, it went on to return 10.2% and 9.3% in 2016 and 2017, respectively, amid ongoing Fed rate hikes. In this piece, I present some updated and different thoughts on how we at GMO think about the impact of rising rates on sovereign hard currency bond spreads. For now, I will limit the discussion to hard currency bond spreads by linking rising rates to the credit fundamentals via public debt sustainability analysis. I find that economic growth matters much more than interest rates to a country’s public debt dynamics. Lower global growth is a much larger risk to emerging markets than higher global interest rates.
As a fixed income asset class with relatively high duration, sovereign emerging debt is sensitive to interest rates. But is there anything else we can say? The yield on a sovereign debt portfolio can be broken down into two main components – the risk-free yield (US Treasury of similar duration) plus a credit spread. Therefore, it is clear that, ceteris paribus, a rise in the US Treasury (UST) yield will lower the price of the portfolio via this risk-free yield component. But need it be the case that a rise in the UST yield also affects the credit spread of the emerging debt portfolio? Thus far in 2018, we have witnessed exactly this phenomenon. Rising UST yields have been associated with rising credit spreads (56 basis points through May 31). But are there historical or theoretical underpinnings that justify this move? This will be the subject of this paper.
In Exhibit 1, we segment the credit spread of the EMBIG benchmark into two components. The smaller component is the pure credit risk premium. Think of this as the spread, in basis points, required to compensate a risk-neutral investor for credit losses due to default. We calculate this using an algorithm we developed that uses ratings transition matrices provided by the rating agencies to calculate default probabilities for countries in the benchmark. When combined with other assumptions, including recovery values in the event of default, we can calculate this “expected credit loss spread.” Notice that this is the smallest of the two components of the overall credit spread. This is because the average credit quality of the benchmark is fairly stable over time, and, indeed, the historical experience is that sovereign defaults are, thankfully, rare. There is, on average, about one sovereign default per year. Moreover, our internal analysis of sovereign defaults over the past 20 to 25 years reveals that they tend to be idiosyncratic and uncorrelated. Therefore, in a benchmark with more than 60 countries, there is a strong diversification benefit (from default risk, anyway). Overall then, it is intuitive to us that this spread component should be relatively small and relatively stable over time. Currently it stands at about 114 basis points.
The other, larger, spread component is a different matter. For the purposes of this paper, we will call it the “risk-averse spread.” This spread compensates the investor for risk aversion, market sentiment, liquidity, and other factors. Not only is it a much larger component (except for the pre-crisis period between 2005 and 2007 when it was about the same as the credit spread premium), but it is also much more volatile. It moves with the vagaries of global markets, and sometimes has little to do with developments within emerging markets. The year 2008 is a case in point. One can see in the exhibit that this risk-averse spread widened to about 700 to 800 bps in 2008, yet the pure credit spread moved relatively little. This is consistent with the observed fact that only one country in the benchmark defaulted in 2008 – Ecuador – which at the time was roughly 1% of the benchmark.
In thinking about the impact of UST rates on emerging sovereign credit spreads, let’s consider each type of spread in turn, beginning with the expected credit loss spread. How might rising interest rates affect this spread? We believe the most direct transmission channel is through the effect on the public debt dynamics, which also represents an important input into our country risk assessment process.
We know from the established algebra of public finance that the primary fiscal balance (the fiscal balance excluding interest payments) that is needed to stabilize a country’s debt-to-GDP ratio is a function of the interest rate on the debt and GDP growth in the following way:2
PB* = Debt-Stabilizing Primary Balance
i = interest rate on public debt
Y = GDP growth
D = Debt-to-GDP ratio
Performing some simple calculus, we know:
Continue reading here.
