Emerging Markets Bonds
China Property Bonds Selloff Appears ContainedFran Rodilosso, Head of Fixed Income ETF Portfolio Management, CFAAugust 31, 2021
The yield and spread pickup of emerging markets (EM) high yield corporate bonds and U.S high yield corporate bonds has widened above historical averages in recent weeks1. The overall average yield for EM high yield is now approximately 5.8%, versus 4.1% for the U.S. market, and the growing difference is driven largely by spread tightening that has occurred in the U.S. while the spread within emerging markets has remained flat year to date. It is probably not surprising, given recent headlines, that much of the recent EM underperformance has been driven by Chinese issuers.
The average spread for dollar denominated high yield bonds of Chinese issuers has widened significantly since the end of last year, driven by certain distressed names in the real estate sector. This sector has endured numerous attempts by the central government to limit leverage, the strictest of which were introduced last year with the “three red lines” test formulated by policymakers. Failure to adhere to these three leverage tests restricts access to additional financing, which has been critical to the growth of many of these companies. More recent regulatory actions by policymakers have not helped, including new steps to reduce speculation in residential real estate. Some heavily indebted property developers have defaulted this year, including China Fortune Land Development. China Evergrande, a very large and heavily indebted developer currently failing these tests, has seen its bonds punished by the market. On average, its U.S. dollar bonds that mature beyond next year are down 45%. Several other developers are also trading at distressed levels.
The silver lining is that the impact of these moves appears to be contained. Market declines in the Chinese real estate sector has not spread to other sectors within China, all of which have positive total returns year to date. Within real estate, lower rated names have been hit hardest. At a broader level, China is the only country among the ten largest by weights in the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index to have experienced overall spread widening this year. For the EM debt market as a whole, lower rated bonds have outperformed, an indication that the volatility in China has not hurt risk appetites across the board.
China: Returns by Sector (12/31/2020 – 8/13/2021)
Spread Widening Contained to China: Top 10 Countries by Weight (12/31/2020 – 8/13/2021)
Source: FactSet. Based on ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index. Option adjusted spread measures the difference in yield between a bond with an embedded option.
Regulatory risks have undoubtedly emerged in China, and investors across asset classes must continue to monitor developments. We also believe that capping country exposure is prudent from a risk management perspective, and overall China exposure is limited to 10% in the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index. Whether current spread levels in the real estate sector represent value depends on developers’ ability to deleverage and adhere to requirements, as well as the potential for additional regulations. Real estate is indeed the largest sector exposure within the high yield China corporate universe, but we note that containment of the market impact aligns with the approach of policymakers, which has been deliberate and targeted. We also note that spread pickup versus U.S high yield at the index level, even when removing China’s contribution, is still above the historical average. Given the higher overall quality and stronger fundamentals of emerging markets high yield compared to U.S. high yield issuers, and the apparent containment of recent market moves to the Chinese real estate sector, we believe that emerging markets high yield corporates may continue to attract interest from income-seeking investors.
1 Emerging markets high yield corporate bonds are represented throughout by the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index, and U.S. high yield corporate bonds is represented by the ICE BofA US High Yield Index. Yield and spread as of 8/13/2021, and compared against 3, 5 and 10-year historical average of difference and yield or spread between Emerging markets high yield corporate bonds and U.S. high yield corporate bonds.
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ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index tracks the performance of US dollar denominated below investment grade emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets.
ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
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