As distressed bonds make a comeback, the world's riskiest EM bonds are in play

For those brave enough to flirt with default, emerging markets' riskiest bond trade is regaining its appeal, offering double-digit returns.

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Emerging-market dollar debt is performing better than ever since 2019, thanks to a rebound in distressed government bonds. El Salvador, a Bitcoin-touting country, Zambia, the pandemic-era defaulter, and Argentina, a serial bailout recipient, all but one of the 10 best-performing developing-economy bonds are in distress.

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Prices recovered from rock-bottom levels last year when traders were overly pessimistic about recovery expectations, leading to the rally. Nevertheless, it reflects the fact that investors have shifted to riskier investments, driving up asset prices across financial markets since the beginning of the year.

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It may turn out that the shift in sentiment was only temporary, but for now, it represents a positive development for investors in distressed securities, a high-risk, high-reward trade in bonds yielding more than 10 percentage points over Treasury bonds.

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A distressed Tunisia bond is one of the emerging markets' top picks for Grantham, Mayo, Van Otterloo & Co., according to Carl Ross, partner and sovereign credit analyst.

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Enticing Returns

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Argentine's dollar bonds due in 2029 trade at around 29 cents to the dollar, more than 60% higher than last summer. El Salvador bonds - this year's best performers - were yielding over 30% at the start of 2023.

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Last year, when fears of widespread defaults and a global recession swept nearly two dozen developing countries into distressed territory, the situation was a drastically different one. Last year, Sri Lanka, sanctions-tangled Russia, and Belarus went into default, but Ukraine won support to delay payments.

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A Trade Algo gauge of emerging-market sovereign dollar bonds fell 17.4% last year, the worst performance ever recorded for emerging-market sovereign dollar bonds. Pakistan-issued bonds lost half their value in 2022 as investors worried about nonpayment.

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Risk Repricing

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International Monetary Fund analysts have since raised their growth forecasts and predicted a slowdown in inflation. There is now a lower risk of default than before Russia invaded Ukraine last February, according to credit default swaps.

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Investors who are seeking value in defaulted bonds have discovered value after prices for some defaulted bonds dropped below their expectations.

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It is estimated that money managers have invested $4 billion in exchange-traded funds that track emerging markets this year, an amount that accounts for the $8.7 billion that has flowed into the asset class. In the last five weeks, the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) has experienced an outflow of $490 million.

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According to Trade Algo data, emerging-market dollar bonds are up about 2.7%, the best start in 2019. This was largely due to an increase in the lowest-rated bonds, up about 11%.

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Warning Signs

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Some recent calls on emerging markets have been tempered by the bullish outlook of distressed investors. According to Citigroup Inc. strategists, the weaker dollar consensus might prove wrong until it is clear how high the Fed will raise interest rates.

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Man Group plc., the world’s biggest hedge fund, is betting on a sell-off in sovereign debt. Analysts at JPMorgan Chase & Co. said sovereign debt is "likely overbought and expensive."

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The country's bonds plunged when voters rejected President Guillermo Lasso's proposed constitutional changes unexpectedly last week, showing how quickly risky trades can go south. For years, the country had performed well, but now it's the worst.

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As a result, investors who have stayed with the trade in 2023 will continue to see strong returns that outperform market returns.

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Picking Winners

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The reasons for optimism are numerous. El Salvador, which investors feared would default, made good on its $800 million bond last month, prompting optimism among bondholders. A restructuring should ease Ghana's debt load after a restructuring by including its local bonds in negotiations with creditors. Furthermore, investors are increasingly confident an Argentina government change is imminent.

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Additionally, the crises brought about by Covid and Russia's war in Ukraine made picking winners easier because some of the weakest credits were eliminated.

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As a London-based analyst at Aviva Investors, Carmen Altenkirch said, "We have a better understanding of which countries can handle it, so assessing risk, reward, and value is easier now than in 2022 or 2021." A greater level of certainty has contributed to the better functioning of the market in recent months.

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