Emerging market bond exchange traded funds have been one the last bastions of strength in the developing markets. However, highly leveraged companies are facing default risks as the decade-long commodity boom fizzles out and the U.S. dollar appreciates.
Year-to-date, the actively managed WisdomTree Emerging Markets Corporate Bond Fund (NasdaqGS: EMCB) fell 3.8%, SPDR BofA Merrill Lynch Emerging Markets Corporate Bond ETF (NYSEArca: EMCD) dipped 0.3% and iShares Emerging Markets Corporate Bond ETF (NYSEArca: CEMB) was down 1.0%. The three bond ETFs track USD-denominated corporate debt.
In the years after the 2008 financial crisis, emerging market corporations issued trillions of dollars of foreign-currency bonds, taking advantage of the low interest rates in developed countries, the Wall Street Journal reports.
Now, emerging market currencies are experiencing a steep depreciation and a plunge in commodity prices have fueled redemptions from emerging markets, adding to fears that emerging companies may not be able to repay their USD-denominated obligations, especially as the Federal Reserve looks to hike interest rates ahead.
Some bond traders, like Ruggero de’Rossi, an emerging-market debt manager at Federated Investors, have reduced exposure to emerging market bonds as the falling commodity prices would make it harder for some issuers to service debt.
The Federal Reserve is also considering hiking interest rates, which would diminish the money supply, strengthen the U.S. dollar and diminish the appeal for riskier emerging market assets.
Furthermore, the International Monetary Fund recently issued a warning on corporate debt of nonfinancial firms across the emerging economies as the highly leveraged firms have quadrupled their debt load over the past 10 years to $18 trillion as of the end of 2014. Emerging market corporate debt to gross domestic product increased 26 percentage points in the past decade to 74%.
“As advanced economies normalize monetary policy, emerging markets should prepare for an increase in corporate failures,” IMF warned.
Other banks are also mirroring the IMF’s sentiments. For instance, J.P. Morgan argues that credit quality among emerging issuers is deteriorating and expects default rates among emerging high-yield issuers to hit 5.4% in 2015, compared to 3.2% in 2014.
The problems are also concentrated in some markets, such as Brazil where spreads between yields of Brazilian corporate debt and U.S. Treasuries have widened to nine percentage points as foreign investors exited the market amid signs of rising political and economic problems. The emerging market corporate bond ETFs also hold heavy positions Brazil, including 14.4% of CEMB, 13.9% of EMCD and 11.4% of EMCB.
For more information on the developing economies, visit our emerging markets category.
Max Chen contributed to this article.