Emerging Market High-Yield Bond Preferences Rise To An Eight-Year High

The risk appetite for emerging market debt is on the rise. Data from J.P. Morgan shows that the spread between high-yield debt and investment-grade sovereign debt has narrowed to 311 basis points, the tightest since May 2018, indicating that funds are increasingly favoring bonds with lower ratings and higher yields.

The direct trigger is the market's reassessment of tail risks following the de-escalation of war in Iran. The ceasefire has driven a rise in emerging market debt, with the risk premium of high-yield debt relative to U.S. Treasuries narrowing by 91 basis points since the end of March to 403 basis points, while the spread for investment-grade debt has only narrowed by 25 basis points to 92 basis points during the same period.

The difference in spread compression reflects the reallocation of funds within the emerging market. The risk compensation for investment-grade debt is already low, and investors who want to continue to lock in higher returns are more likely to turn to lower-rated high-yield debt. Since the end of 2022, investors have continued to buy emerging market high-yield debt, with some countries that defaulted during the pandemic restoring their credit status with IMF assistance and fiscal reforms, and bringing double-digit annual returns to investors.

Nick Eisinger, Head of Emerging Market Sovereign Strategy at J.P. Morgan Asset Management, said that if the crisis ends more quickly, market concerns about high oil prices in the long term and economic slowdown may diminish. In a more favorable macro environment, emerging market high-yield debt may outperform investment-grade debt, as the spreads for the latter are already tight.

Leading assets also indicate that funds are moving towards the higher risk end. Over the past five weeks, the total return on Lebanese dollar debt has reached 15%, and issuers such as Mozambique and the Republic of Congo, who were in default or dire straits a few years ago, have also recorded double-digit returns. S&P Global Ratings and Fitch Ratings warn that if the conflict in the Middle East lasts longer, the credit risk of emerging markets may be impacted; bulls, however, are betting that foreign exchange reserves, IMF programs, reduced refinancing pressure, and improved fiscal deficits are enough to cushion the relevant sovereign debt.