Exploring the risks and opportunities of investing in Emerging Market sovereign debt

Robert Simpson, Co-Head EM Hard Currency Debt at Pictet Asset Management.

Robert Simpson, Co-Head EM Hard Currency Debt at Pictet Asset Management, discusses the main drivers of sovereign debt issuance in emerging markets and how they impact the risk and return characteristics of these investments. He also shares his insights on the risks and opportunities associated with investing in emerging market sovereign debt and how recent bank failures have affected demand for these investments.

What are the main drivers of sovereign debt issuance in emerging markets, and how do these factors affect the risk and return characteristics of these investments? 

Sovereigns issue mainly for the purpose of financing their budgetary needs. As countries develop and their domestic financial systems develop they are able to issue more and more in their domestic markets but at times may also rely on international financing for budgetary needs.

Those that are able to issue domestically tend to display lower risk than those that rely largely on foreign financing. When issuing in foreign currency it is important to be able to have access to foreign currency in order to service that debt either through export revenues or continued access to markets.

What actual risks and opportunities do you see associated with investing in emerging market sovereign debt? 

The opportunity is very attractive driven by investing in some of the highest growth countries in the world with much more favorable demographics and debt profiles than the developed world. The market is incredibly diversified with the hard currency universe representing around 75 countries across all parts of the globe. It is also diversified across rating categories from very high-quality investment grade to higher yield issues. The hard currency universe itself is 50% IG and 50% HY with an average yield (around 8.5%) much closer to that of a high-yield universe so it looks attractive relative to other credit asset classes.

Also in sovereigns default rates tend to be lower and with higher recovery rates than HY corporates. When investing in domestic markets the international investor takes a risk in the form of movements in the domestic interest rates and fixed-income markets as well as currency volatility risk. In international bond markets the risk is that the country may no longer be able to service that debt either through lack of access to foreign currency or through the debt load becoming too onerous to service.

Have recent bank failures, such as Silicon Valley Bank and Credit Suisse, affected the demand for emerging market sovereign debt?

Not at the moment. We see the current issues as concentrated in developed markets. Emerging market sovereigns are actually seeing improved financing conditions relative to 2022 with new issuance run rate well ahead of that of last year. In the last few weeks alone there have been a number of new issues that have attracted very large orders from international investors. Equally, sovereigns have access to other forms of financing including multilateral and bilateral loans often and concessionary interest rates.

What impact have regulatory changes in the wake of bank failures had on the risk profile of emerging market sovereign debt?

No real direct impact. The demand for EM sovereign debt had been taken out of the banking system a long time ago. Emerging market sovereign investors don’t display the level of risk mismatches and leverage that private asset vehicles will have so there has not been any direct impact.

In light of recent bank failures, how have investors’ perceptions of the creditworthiness of emerging market sovereigns changed?

Spreads have been very contained. EM sovereigns are not where the issue lies in terms of the current risks. We are cognizant of the risks of tighter global financing conditions and how this may affect EM but it’s indirect. As said earlier, sovereigns have access to a broader array of financing sources and the diversification inherent in the market lowers that risk. 

How have emerging market governments responded to concerns over the stability of their banking sectors and the potential impact on their sovereign debt markets? 

There haven’t really been any direct impacts. Some countries with developed banking systems have been keen to clarify the local regulations as regards the treatment of subordinated capital in their systems and also to reassure over the level of capital in the system. Where there was some immediate impact on bond prices after the CS news this has subsided significantly since.