Loading summary
Transcript19 lines
- [00:01]
Andrew Sheats
Welcome to Thoughts in the Market. I'm Andrew Sheats, Head of Corporate Credit Research at Morgan Stanley.
- [00:06]
Neville Mandimiga
And I'm Neville Mandimiga from the Emerging Markets Credit Strategy team with a focus on Cimilla.
- [00:10]
An Lynn Zhang
And I'm An Lynn Zhang, US Credit Strategist.
- [00:13]
Andrew Sheats
And today on the program we're going to talk about high yield bonds in the US and emerging markets and why we think emerging markets or EM in many cases offer better opportunity. It's Friday, March 21st at 2pm in.
- [00:27]
An Lynn Zhang
London and it's 10am in New York.
- [00:31]
Andrew Sheats
So Neville and Lynn, it's great to talk to you and I want to talk to you about a recent report that we all wrote looking at the market for high yield bonds in both the US and emerging markets. In some ways these two markets are similar. Both represent bonds with ratings below investment grade. Both are denominated in US dollars and both offer more elevated yields. But they're also quite different. The US High yield market represents lending to companies in the United States. The EM market for our purposes represents lending to countries. So Neville, that's where I'd like to start. When you think about that risk of lending to countries that carry lower ratings, what are some of the key metrics that you look at to determine if you're being compensated for that risk?
- [01:12]
Neville Mandimiga
We look at three distinct factors, the first one being fundamentals, including credit ratings as to whether they're getting worse or better. We also look at so called technicals which show you how much a country needs to issue and how investors are already positioned in a country's sovereign debt. And and then finally valuations, what investors are being paid to take on that risk and that is often presented in yields, spreads and sometimes cash prices.
- [01:37]
Andrew Sheats
And so Neville, obviously the emerging market high yield sovereign space covers a lot of different countries that are dealing with a lot of different issues. But if you had to generalize over all of those three factors, how do they currently look?
- [01:49]
Neville Mandimiga
On the first point of fundamentals, I would say since the COVID pandemic we have seen a steady improvement in debt and fiscal ratios as countries have sought to create some room in order to be able to absorb future shocks. So the so called fiscal room, and they've done this in a number of ways, chief amongst them being, you know, going to the International Monetary Fund in order to create a sustainable fiscal framework. That said, the work is not yet done. Debt levels are still quite high relative to history and expenditures are still outpacing revenues by some margin. But the overall direction, and I think this is the point to stress the overall direction is positive. Hence we see a number of high yield countries with positive outlooks from the three major rating agencies. And Andrew, on the second point of technicals, I think this is where EM the selling point is really quite strong. So with fiscal improvements steadily happening, the need to raise a lot of debt has left us with the view that EM issuance will only see a 7% year on year increase which is quite small relative to history and relative to the US which I'm sure Anlen will touch on. This is quite positive as demand relative to supply should remain in a steady balance allowing for yields and spread to maintain somewhat of a downward trajectory in line with our 2025 forecast. And then lastly, on the point of positioning, I would say EM high yield is actually not that over owned by EM dedicated investors with allocations being in line with history. And this partly explains the resilience of EM high yield so far this year despite headlines which I'm sure you'd agree have been fast and furious.
- [03:28]
Andrew Sheats
So Anlin, kind of asking similar questions to you as you look at US high yield, how does the fundamental the supply and demand and valuation backdrop look in that market?
- [03:39]
An Lynn Zhang
In US high yield we find agri fundamentals are holding up despite high rates. Earnings are on the path to recovery with double digit earnings growth rebound expected by the market this year. However, dispersion across ratings is high with the lower quality triple C cohort seeing weaker trends and being vulnerable in a higher for longer rates backdrop. Now in terms of technicals, technicals are less favorable in US high yield versus the EM high yield market. On the demand side, we believe strong demand tailwinds can persist with high rates and attractive all in yields. On the supply front though, 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 yen as issuance picks up. We expect supply and demand to come into better balance in 2025, but this would be less of a positive technical for high yield investors in terms of valuations, USBBs and single Bs trade tight relative to history, but we believe spreads can stay near current tight levels through year end. We think the setup for credit is healthy with corporate fundamentals holding up and demand strong. As mentioned, however, risks to the downside have recently come up with higher and broader tariffs and layoffs in the government which imply weaker growth in the US and stickier inflation. Despite this, the revised outlook from the ECON team still suggests a decent growth environment for our market, but we acknowledge that A further slowdown will challenge the resilience of US credit.
- [05:12]
Andrew Sheats
So kind of putting that together, we have a market and emerging market high yield, where ratings trends, those fundamentals look a little bit better, where the relative supply and demand balance could also look a little bit better, and where relative valuations of EM high yield relative to US corporate high yield are also pretty favorable. Three things that all seem to be moving in a favorable direction towards EM high yield. But Neville, one concern that comes up in some of these conversations is the tariff backdrop, the trade backdrop. How do you think about emerging market high yield in the context of some of those risks?
- [05:49]
Neville Mandimiga
Yeah, I mean, it's certainly been a huge conversational point with clients, as you can imagine, as the reality is that we have to do a lot of permutations, right, in terms of what tariffs are going to look like over the next few weeks and months ahead. And I would broadly classify the impact as coming from two direct channels. So the direct impact and then the indirect impact. So from a direct standpoint, it would be very country specific, similar to what we saw with Mexico a few weeks ago. Fundamentally, you would imagine that, you know, if tariffs were to suddenly go up, this would affect exports and ultimately economic growth. Where EM high yield I think is an overall sub asset class, where it could get affected is through the indirect channel. So if, for example, we were to see a massive ramp up in tariffs in a way that causes fears of a U.S. recession and the Fed has to suddenly start cutting rates aggressively, EM spreads would struggle very much to hold up well in that environment. And as you can imagine, market access for some of the lower EM high yield countries would struggle to issue debt at fairly reasonable levels and that access would quickly go away. So for as long as tariff increases are gradual and in a somewhat predictable way, we think that EM holds up well. And to put it differently, if I can borrow your phrase, Andrew, EM does love moderation as well. So for now we think that US money managers should continue to position in selective BB credits where fundamentals are okay. Tariff exposure is potentially more minimal, valuation present as cheap and liquidity in cash and CDS curves is quite high.
- [07:23]
Andrew Sheats
So Anlin, it's also fair to say that the tariff story matters for the US high yield market. Where do you think the highest exposures could be?
- [07:31]
An Lynn Zhang
Tariffs are a big story for US consumer retail. Our credit analyst Jenna Giannelli views specialty retail as most at risk and less so for department stores and brands. For US high yield in aggregate, sectors with high exposure to tariffs on China have a rather limited representation in the US Credit market. Top down sector analysis done by our equity strategist shows the top three sectors with meaningful exposure are consumer discretionary, consumer durables, and apparel and tech hardware. These account for only around 5% by market value in the US High Yield Index.
- [08:08]
Andrew Sheats
So just putting this all together, we entered this year at Morgan Stanley thinking that US High yield would hold up pretty well in the first half of this year, with maybe a more challenging second half of the year as US Tariff policy started to escalate. And even though our base case is still that spreads stay relatively low, it's clear that the risks to this view are rising as US Policy uncertainty has gone up and our forecasts in the US for growth have gone down. In that context, we're looking out for markets that might offer better risk reward and we think that emerging market high yield sovereigns could qualify Neville, thanks so much for taking the time to talk. Thanks Andrew and Anlin, thanks for taking the time as well.
- [08:48]
An Lynn Zhang
Thank you.
- [08:49]
Andrew Sheats
And to our listeners, thanks for listening. If you enjoy the show, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.
- [08:58]
Unknown
The preceding content is informational only and based on information available when clicking created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.