Podcast Summary: "Investors Look Beyond U.S. for Opportunities"

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Description: Short, thoughtful, and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
• Episode: Investors Look Beyond U.S. for Opportunities
• Release Date: March 21, 2025

Introduction

In the March 21, 2025 episode of "Thoughts on the Market", Morgan Stanley hosts Andrew Sheats, Head of Corporate Credit Research, alongside Neville Mandimiga from the Emerging Markets Credit Strategy team and An Lynn Zhang, US Credit Strategist. The episode delves into the comparative analysis of high yield bonds in the U.S. and Emerging Markets (EM), exploring why EM might present more favorable opportunities for investors.

Overview of High Yield Bonds

Andrew Sheats introduces the topic by highlighting the similarities and differences between U.S. and Emerging Market high yield bonds. Both are below investment grade, denominated in U.S. dollars, and offer elevated yields. However, the U.S. market pertains to lending to American companies, whereas the EM market involves lending to sovereign nations.

Quote:

Andrew Sheats [00:13]: "Both represent bonds with ratings below investment grade. Both are denominated in US dollars and both offer more elevated yields."

Emerging Markets High Yield Bonds Analysis

Neville Mandimiga outlines three key metrics used to assess the risk and compensation in lending to lower-rated countries:

1. Fundamentals: Evaluates credit ratings trends and fiscal health.
2. Technicals: Assesses debt issuance needs and investor positioning.
3. Valuations: Looks at yields, spreads, and cash prices to determine risk compensation.

Quote:

Neville Mandimiga [01:12]: "We look at three distinct factors, the first one being fundamentals... the second being technicals... and then finally valuations."

Current State of EM High Yield Markets

• Fundamentals: Since the COVID-19 pandemic, many EM countries have improved debt and fiscal ratios by seeking support from the International Monetary Fund and establishing sustainable fiscal frameworks. However, debt levels remain historically high, and expenditures slightly outpace revenues.

  Quote:

  Neville Mandimiga [01:49]: "Since the COVID pandemic we have seen a steady improvement in debt and fiscal ratios... the overall direction is positive."

• Technicals: EM debt issuance is projected to increase by only 7% year-on-year, a modest rise compared to historical trends and the U.S., suggesting a balanced demand-supply dynamic that could lead to decreasing yields and spreads.

  Quote:

  Neville Mandimiga [02:00]: "...EM issuance will only see a 7% year on year increase... allowing for yields and spread to maintain somewhat of a downward trajectory."

• Valuations and Positioning: EM high yield bonds are not excessively owned by dedicated investors, maintaining historical allocation levels and demonstrating resilience despite volatile headlines.

  Quote:

  Neville Mandimiga [02:20]: "EM high yield is actually not that over owned by EM dedicated investors with allocations being in line with history."

U.S. High Yield Bonds Analysis

An Lynn Zhang provides an in-depth look into the U.S. high yield market, highlighting its current state and future outlook.

• Fundamentals: Despite high interest rates, agricultural fundamentals are holding steady, and earnings are rebounding with double-digit growth expected. However, there's significant dispersion across ratings, with lower-rated (Triple C) bonds showing weaker performance amid enduring high rates.

  Quote:

  An Lynn Zhang [03:38]: "Earnings are on the path to recovery with double digit earnings growth rebound expected by the market this year."

• Technicals: The U.S. high yield market faces less favorable technicals compared to EM. Issuance is expected to grow by approximately 40% year-on-year, significantly higher than EM, potentially tightening the supply-demand balance and increasing valuations.

  Quote:

  An Lynn Zhang [04:05]: "We forecast issuance to increase more year over year in US high yield at around 40% year over year versus a more modest increase in EM."

• Valuations and Positioning: U.S. bonds like USBBs and single Bs are trading tight relative to historical levels. While credit fundamentals remain healthy, risks such as higher tariffs and potential layoffs pose threats to growth and inflation stability.

  Quote:

  An Lynn Zhang [04:50]: "We believe spreads can stay near current tight levels through year end... risks to the downside have recently come up with higher and broader tariffs and layoffs."

Comparative Assessment: EM vs. U.S. High Yield

Andrew Sheats synthesizes the insights, emphasizing that EM high yield markets currently present more favorable conditions compared to the U.S.:

1. Improving Fundamentals: EM countries are showing positive credit outlooks.
2. Balanced Supply and Demand: Moderate debt issuance in EM supports stable or decreasing yields.
3. Attractive Valuations: EM high yield bonds are priced more attractively relative to their U.S. counterparts.

Quote:

Andrew Sheats [05:12]: "We have a market and emerging market high yield, where ratings trends, those fundamentals look a little bit better... Three things that all seem to be moving in a favorable direction towards EM high yield."

Risks: Tariffs and Trade Backdrop

The discussion shifts to the potential risks posed by tariffs and the broader trade environment.

Impact on EM High Yield

Neville explains that tariff increases can affect EM high yield bonds through two channels:

1. Direct Impact: Varies by country, affecting exports and economic growth.
2. Indirect Impact: A significant ramp-up in tariffs could trigger fears of a U.S. recession, leading to aggressive rate cuts by the Federal Reserve, which would negatively impact EM spreads and market access.

Quote:

Neville Mandimiga [05:49]: "The impact as coming from two direct channels... if tariffs were to suddenly go up, this would affect exports and ultimately economic growth."

He reassures that gradual and predictable tariff increases allow EM high yield bonds to remain resilient.

Quote:

Neville Mandimiga [07:23]: "...if tariff increases are gradual and in a somewhat predictable way, we think that EM holds up well."

Impact on U.S. High Yield

An Lynn Zhang identifies sectors within the U.S. high yield market that are most exposed to tariffs, notably consumer retail, specialty retail, consumer discretionary, consumer durables, apparel, and tech hardware. However, these sectors constitute only about 5% of the U.S. High Yield Index, indicating limited overall exposure.

Quote:

An Lynn Zhang [07:31]: "Tariffs are a big story for US consumer retail... These account for only around 5% by market value in the US High Yield Index."

Conclusion

Andrew Sheats concludes the episode by reaffirming Morgan Stanley's strategic outlook. While the U.S. high yield market showed promise in the first half of the year, escalating tariff policies and increased growth uncertainties highlight the rising risks. Consequently, Emerging Market high yield sovereigns emerge as more attractive opportunities offering better risk-reward profiles.

Final Quote:

Andrew Sheats [08:07]: "We think that emerging market high yield sovereigns could qualify."

Key Takeaways:

• Emerging Markets (EM) High Yield Bonds: Currently offer better fundamentals, balanced supply-demand dynamics, and more attractive valuations compared to U.S. high yield bonds.
• U.S. High Yield Bonds: Face challenges from increasing debt issuance and potential economic headwinds due to tariffs and inflation concerns.
• Risks: Tariffs and trade policies pose risks to both markets, but EM bonds are better positioned to withstand gradual tariff increases.
• Investment Strategy: Morgan Stanley suggests favoring selective EM high yield sovereigns for improved risk-adjusted returns.

Notable Quotes:

• Andrew Sheats [00:13]: "Both represent bonds with ratings below investment grade. Both are denominated in US dollars and both offer more elevated yields."
• Neville Mandimiga [01:12]: "We look at three distinct factors, the first one being fundamentals... the second being technicals... and then finally valuations."
• An Lynn Zhang [03:38]: "Earnings are on the path to recovery with double digit earnings growth rebound expected by the market this year."
• Andrew Sheats [05:12]: "Three things that all seem to be moving in a favorable direction towards EM high yield."
• Neville Mandimiga [05:49]: "The impact as coming from two direct channels..."
• Andrew Sheats [08:07]: "We think that emerging market high yield sovereigns could qualify."

For Further Listening: If you found this summary insightful, consider listening to the full episode of "Thoughts on the Market" on your preferred podcast platform. Share your thoughts and engage with fellow investors to enhance your market perspectives.