Fixed Income

EMD Relative weekly notes: Week Ending May 8, 2020

James Barrineau

James Barrineau

Head of Global EMD Strategy

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Healing signs

  • Aside from asset prices, underlying technicals are favoring – for now – a continued healing for the asset class.
  • This implies investment grade spreads can tighten further, especially in the most liquid bonds. Non-investment grade debt spread tightening will eventually be limited by poor fundamentals.

We are seeing a steady and pretty decisive recovery for assets into the largest EMD ETF (see Figure 1). While the month of April was marked by outperformance of corporates versus sovereigns across all credit ratings, continued passive flows will mean more liquid sovereigns are likely to catch up.

Figure 1


Source: Bloomberg. The chart above depicts assets under management for the EMB ETF for the period of January 1, 2015 through May 6, 2020. There is no guarantee that historical trends will continue.

Spreads have tightened in response: in the last week IG sovereign debt has tightened 29 basis points while BB debt has tightened 58 basis points. Both are still wide of virtually every previous stress episode since the global financial crisis.

The second positive dynamic is lowered volatility and lowered market-based default probabilities (see Figure 2). Our aggregate of credit default swap spreads has reached a rough ceiling after skyrocketing, while FX volatility has declined very sharply. All of this follows on with the decline in developed market volatility which preceded it.

Figure 2


Source: Bloomberg. The chart above depicts EM CDS spreads for the period of November 7, 2019 through May 6, 2020. There is no guarantee that historical trends will continue.

We don't take any of this as an "all clear" signal. Part of the IG spread compression can be explained by a rise in treasury yields. The non-investment grade space is still likely to see continued and steady downgrade pressure and a high level of defaults at the lowest rating categories. However, signs that investors are more accepting of emerging market debt risk is a necessary condition for spreads to developed markets – which will share the same stresses as global growth struggles – to fall sustainably.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.