Emerging-Market Debt: Higher Quality, Higher Yield?

Over the past decade, the difference in yields between investment-grade EMD and investment-grade US corporates had narrowed steadily, reflecting converging average credit quality.
Then came COVID-19.
EMD spreads remain wider than normal. This disconnect between fundamentals and valuations signals opportunity.
By Shamaila Khan
As the coronavirus crisis unfolded, prices tumbled and yields spiked to record highs across investment-grade emerging-market debt (EMD) - a sector widely considered to have healthy credit fundamentals and a low risk of defaults.
Yield Gap Widens with US Corporates Over the past decade, the difference in yields between investment-grade EMD and investment-grade US corporates had narrowed steadily, reflecting converging average credit quality. Then came COVID-19.
The pandemic triggered massive market declines as investors rushed to free up cash. Indiscriminate selling hit some of the highest-quality sectors of the market, including investment-grade EMD. Spreads over US Treasuries climbed sharply as prices fell.
The investment-grade EMD sector has rallied in the two months since then. But today's spreads remain wide, particularly in investment-grade emerging-market (EM) corporates, both by historical measures and compared with spreads on US investment-grade corporates (Display 1).

Why the sudden yawning gap between these sectors? Rather than deteriorating fundamentals, the wider spread between EMD and US corporates reflects a sizable-but short-term-technical factor. In the early stages of the market drawdown, investment-grade EM corporates and US investment-grade corporates performed in line with one another.
But when the US Federal Reserve announced expanded purchase facilities for US corporate bonds, the recovery in US credit accelerated, leaving investment-grade EMD trailing behind. While investment-grade EM sovereigns have recovered on a relative basis, investment-grade EM corporates still have room to recover, as... Read more