Why emerging market high yield debt will rally as defaults increase
Pandemic throwing up more surprises
When selecting where to invest, one cannot take an overly simplistic view of the markets and individual securities. Unfortunately, this has been especially prevalent since the outbreak of the coronavirus pandemic.
Private investors flocked into supermarket stocks in March as the newspapers were filled with reports of panic buying and enormous queues. Yet increased costs and higher sales of lower-margin products meant this had a limited impact on their bottom line.
It is a similar story in the healthcare sector; pharmaceuticals soared on every rumour of a breakthrough in developing a treatment for Covid-19, yet numerous biotech managers - some of whom own these stocks in their portfolio - have warned the public mood means these companies would be unlikely to charge much more than cost price for such a drug.
The good news is that this oversimplification works the other way, too, creating opportunities for investors who are willing to look past face value. The emerging market corporate high yield debt is a good example.
Record company debt levels set to soar by $1trn in 2020 - Janus Henderson
Like most asset classes, it has rebounded strongly from its March lows, yet a number of dislocations remain, the most important of which is between credits of different qualities.
The lowest quality debt in this sector sold off heavily in March's crash, which is to be expected. As people scramble for liquidity in times of crisis, they feel more comfortable hanging on to higher quality assets, which is why distressed credits were the first to go.
Yet as a result, the lowest quality area of this market now looks extremely attractive, with many assets priced at recovery values and in some cases even lower.
Current valuations across this sector are implying defaults on a scale never seen before - and on a scale well beyond what the ratings agencies are expecting.
Notably, the latest statistics from Moody's show recovery rates on emerging market debt have improved significantly over the past few years and are now higher than those in developed markets.
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Yet while valuations reflect an overly pessimistic scenario, we know a spike in defaults is on the way. Every economy on the planet has taken a major hit, and we are seeing defaults and restructurings.
Some of these restructuring programmes are cannot even be regarded as defaults as they do not disadvantage the creditors - for example, in cases where maturity is extended, the credit holder is often paid for that extension via an additional coupon or bonds.
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