It used to be unthinkable for a nation to default on its debt obligations. If the United States were ever to truly default on its full faith and credit Treasury bonds, it would create a new global financial pandemic. Yet in 2020, under the COVID-19 instant recession, sovereign debt defaults in emerging markets are likely to become much more common. This puts billions of dollars at risk for emerging market and junk bond investors who chase high yields and high growth.
When corporations default on their debt, it usually wipes out the common shareholders. When nations default on debt, long negotiations and court cases come into play. Generally speaking, it is hard for non-governmental creditors, except for the most nimble and deep-pocketed investors, to get all of their money back under sovereign debt defaults.
According to Fitch Ratings, 2020 is going to be a record year for sovereign debt defaults. A report from May 12 predicts more sovereign debt defaults on top of the defaults already seen by Argentina, Ecuador and Lebanon, which matched the record of three defaults back in 2017.
24/7 Wall St. has tracked some additional reporting and figures (see below) that would show how large this risk is for investors. It turns out some investors may have emerging market debt exposure without even knowing it. It is not an overstatement to project that this could equate to hundreds of billions of dollars at risk tracking emerging market debt and emerging markets.
Fitch’s report indicated that sovereign debt defaults are not so common. It recorded 23 defaults of its rated sovereigns from just 14 countries since starting sovereign credit ratings coverage in the mid-1990s. Argentina has been a serial default offender, and Congo, El Salvador and Jamaica were nations with multiple defaults.
The main blame is on the severe shock from the COVID-19 crisis and plunging oil prices. Fitch warned:
The sovereigns most exposed are those with generally weak credit fundamentals, such as high debt and weak policy credibility; and those reliant on commodity exports or tourism, or with large external financing requirements, foreign-currency debt, hot-money inflows and low reserve buffers.
In just the first four months of 2020, Fitch pointed out that there were a record 29 sovereign credit rating downgrades. Eight of those downgrades also have been within the CCC/CC/C/RD range, with a D rating representing defaults. Despite the downgrades, 28 also have had a net negative Outlook, versus just four at the end of 2019.
Fitch warns that this amplifies the longer-term trend of declining average emerging-market ratings and that 29% of all ratings are now in the B/C/D categories. Fitch also pointed out that few CCC/CC sovereign ratings avoid default. The average annual default rate from 1995 through 2019 for that range in the various C sovereigns was 26.5%, but the cumulative five-year default rate was 38.5%.
There are currently five sovereign ratings at CCC or worse by Fitch that are not yet in default:
- Gabon (CCC)
- Mozambique (CCC)
- Republic of Congo (CCC)
- Suriname (CCC)
- Zambia (CC)
According to the Closed-End Fund Center, there are currently seven closed-end mutual funds with just over $2 billion in assets tracking emerging market debt and another $3.4 billion tracking emerging markets in equities. Where the real problem exists is that there is a combined $17.3 billion in high yield funds, and many of those funds have emerging market debt. Another $7.5 billion in assets were held by global income closed-end funds, and some of those hold emerging market debt. The website MutualFunds.com also shows that there are hundreds of billions worth of traditional mutual fund assets in emerging market funds, which also includes direct and indirect exposure to emerging market debt.
There are also billions of dollars in assets in emerging market bond exchange-traded funds. The ETFdb.com site showed that the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB) had more than $12.7 billion in assets alone, followed by other emerging market bond ETFs with billions and hundreds of millions of dollars managed within each.
Before thinking about waves of sovereign credit defaults, note that the International Monetary Fund already telegraphed in April that concessions will need to be made. The IMF said:
Multilateral cooperation is vital to the health of the global recovery. To support needed spending in developing countries, bilateral creditors and international financial institutions should provide concessional financing, grants, and debt relief. The activation and establishment of swap lines between major central banks has helped ease shortages in international liquidity, and may need to be expanded to more economies. Collaborative effort is needed to ensure that the world does not de-globalize, so the recovery is not damaged by further losses to productivity.
It is no secret that 2020 has been a challenging year for the global economy and for investors alike. Despite the trillions of dollars in global stimulus efforts to date, it sounds like many emerging market investors may have a bumpy year ahead.
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