EMD Relative weekly notes: Week Ending November 20, 2020

What is lofty can stay lofty longer

  • Emerging market investment grade dollar debt has reached pre-pandemic spread levels, wringing a lot of value and a margin of safety from this sector. Yet history shows extended valuation levels can linger for long periods.
  • A further move lower in spreads would likely only be motivated by a meaningful move lower in the US dollar. If that transpires there is bigger bang for your buck in local debt and high yield within EMD.
  • A floor for spreads is almost certainly US corporate IG debt, currently about 45 basis points tighter than EM IG.

Current IG spreads are about 160 basis points over treasuries, very near 15-year lows, a neighborhood we have visited four times in the post GFC period.

The march to tighter spreads post-pandemic blowout has been relentless but a near-term reversal seems unlikely. Over the past twenty years as shown in Figure 1, when the average of 209 basis points has been breached for longer periods it is generally correlated with Fed easing. The dramatic bottom near 100 basis points occurred around the culmination of the dollar weakening cycle in early 2008. 

Figure 1


Source: Bloomberg, as of November 18, 2020. The chart measures yield spreads of the investment grade component of the JPMorgan EMBI Global Diversified Index over US treasuries. This data is for the period of January 1, 2000 through November 18, 2020. Past performance is no guarantee of future results. Performance for other time periods would differ.

Aside from that, it’s easy to see that the Fed was generally the driver, with breaches of the average level of spreads happening with the "Taper Tantrum" of 2013 and the Fed modest tightening cycle until late 2018.

Today, with the Fed pinned to zero likely for years, history suggests we will be in this zip code of spreads for some time. Crossover investors can pick up what now passes for attractive additional yield over US IG corporates and be relatively comfortable with the probability for limited idiosyncratic downside, but should the dollar weaken better total returns likely reside in other parts of the asset class.

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.