Investors consider global distressed debt risks, opportunities

Emerging markets managers are trained to be both pessimists with a healthy dose of Pollyanna optimism. And even during the COVID pandemic, there are many wondering whether the credit boom is finally going to go bust. Investors have been keeping watch on a wide range of opportunities in the credit space since the pandemic started as distressed funds collected billions following March’s market downturn. According to consultant Cambridge Associates, an extended downturn could generate significant opportunities given the combined $2.5 trillion in high-yield and loan markets. The firm states in a recent white paper on the opportunities emerging out of 2020, that it remains unclear whether these commitments should be the first priority for investors as default rates are rising and are concentrated in industries such as energy and retail. But should there be a V shaped recovery, Cambridge and other firms expect a possibility of a quick recovery that allows companies on the brink to survive, thanks to looser lending protections. But what does this mean for emerging markets investors facing arguably a steep uphill battle in avoiding defaults? The emerging market debt spread in early March advanced to nearly 700 basis points and it is now only 30 basis points away from the pre-crisis level, according to Lyxor Asset Management. For the most part, an ongoing economic recovery is underway in emerging market countries. This rally in emerging market assets has eroded the potential for alpha generation, but hedge fund managers are currently staying long on average while keeping dry powder to capture opportunities at a later stage, analysts at Lyxor added. “We therefore expect a more discriminating environment for EM assets to return, favorable for alpha generation,” analysts wrote in a recent Lyxor briefing. “In the meantime, we still think EM debt provides valuable diversification in credit portfolio, with an annualized 4%-5% yields.” For more than 20 years, Gramercy has been an active investor in emerging markets with satellite offices in London and Buenos Aires and dedicated lending platforms in Mexico City and Istanbul. The Connecticut-based firm offers alternative and long-only strategies across emerging markets asset classes including multi-asset, capital solutions, private credit, distressed debt, USD and local currency, sovereign, high yield/corporate debt and special situations. Now the firm is looking forward to what is next for its wide-ranging investment portfolio, specifically what the future holds for emerging market high-yield corporate debt. “Just as EM obligors grapple with the worst recession since World War II, they have found refuge in the recent rebound in global credit markets – pulled along by stimulus measures in developed markets,” the investment team at Gramercy wrote in a recent white paper, titled, “The Coming Cycle High Yield Defaults.” According to the Gramercy team’s historical analysis of previous emerging markets credit crises, there are pre-existing conditions that correspond with an increase in credit defaults. The risk of defaults remains high as shown in investment models quantifying credit stress to be three to four-times greater than the 2.5% high yield default rate recorded by S&P in 2019. Compounding matters are flighty investors. According to Gramercy defaults of corporate high yield emerging market debt will indeed test new highs, unsurprisingly thanks to weakened corporate fundamentals and a transition from global GDP growth to contraction in 2020, again a phenomenon not seen since World War II, researchers added. Yet, the firm is taking a contrarian view in that at the current pricing levels the market is not on the verge of a historic spike in defaults, although the COVID-19 pandemic, challenging fundamentals and panicky investors seem to indicate otherwise. “First, the waterfall of global central bank liquidity could continue unabated,” according to the Gramercy analysis. “In this scenario, risk tolerance would remain at historic highs and global investors would continue to support a fundamentally deteriorating asset class. Simply put: the music could keep playing, and investors dancing.” Low interest rates in developed markets continue to give investors good reason to take risk in order to source greater yields. Emerging markets could become victims of their own success and see spreads compress in relation to developed markets yet Gramercy views emerging markets following the path of other developed counties and assume massive budgetary deficits. Developed markets, such as the U.S. and Japan have dedicated as much as 20% of their GDP to combat the pandemic shutdown and more will likely be spent next year. Meanwhile, Brazil and Ecuador have dedicated far less due to the inability to set aside more than 5% to battle the virus. At least for now, Gramercy sees emerging market high yield corporate obligors who were waiting on a bailout are unlikely to see governments budge. And with that reality the risk of default seems to be increasing substantially. Still, the Gramercy analysts added that emerging market investors cognizant of the challenges while remaining conservative in underwriting and nimble around entry points can still make money in this unique form of distressed corporate credit.

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