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Emerging-market credit spreads play catch-up as dollar weakens – risk monitor

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Emerging-market credit spreads play catch-up as dollar weakens – risk monitor

The dollar-denominated emerging-market corporate bond market has been slower to return to pre-pandemic levels than the domestic U.S. bond markets. But with the Dollar Index falling 4.1% in July, the biggest drop in a decade, investors are looking to assets such as emerging-market debt and commodities that strengthen when the greenback weakens.

The emerging-market corporate spread fell 3 basis points between July 27 and Aug. 3 to 366 bps, meaning the spread has reversed 70% of the widening experienced during the peak of the financial markets' coronavirus-induced panic.

"Investors are having to rethink what portfolios they want to run over the next few months and focus on regions or asset classes that benefit from a weakening dollar," said Marc Franklin, head of flexible multiasset at NN Investment Partners. "Both emerging market bonds and equities are relatively attractive, but especially the former, both sovereign and corporate, because of the steadier returns they offer."

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With notable exceptions such as Brazil, India, Mexico and Turkey, emerging market countries have generally had a good crisis, minimizing outbreaks and preserving economies.

"Absent a second wave of the pandemic, emerging markets are thus in relatively sound financial shape, with their equity markets and currencies recovering and their policies supportive," Tamara Basic Vasiljev, a senior economist at Oxford Economics, wrote in a research note. "The overall credit cycle is clearly on the upswing across the emerging markets."

The U.S. high-yield corporate bond market saw spreads continue to decline. Between July 28 and Aug. 3, the spread shed 19 bps to 508 bps. Having been slower to normalize than the investment grade market, the high-yield spread has been rapidly catching up, declining by 128 bps in July alone. The spread has now retraced 79.3% of the effects of COVID-19 in March.

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The investment-grade corporate bond spread was more stable, unchanged between July 28 and Aug. 3 at 140 bps, having retraced 87.3% of the spike in March after reaching 401 bps on March 23.

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The volatility that had abounded in U.S. equities in recent months has continued to ease. The CBOE's volatility index — or VIX — fell almost 2 points in the past week, to 23.8 on Aug. 4, the lowest level since Feb. 21.

The VIX averaged 27.0 in July, down from 31.1 in June.

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In the leveraged loan market, the percentage of companies priced below 80.0 — a closely watched indicator suggesting a company is more likely to default — has been rangebound between 7.5% and 8.5% since June 19.

The level increased from 7.6% on July 28 to 7.9% on Aug. 3.

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The Libor-OIS spread, a key risk indicator for the U.S. banking sector, contracted.

The spread, which measures the difference between the three-month dollar London interbank offered rate, and the overnight indexed swap rate, was 16.6 bps as of Aug. 4, down from 18.8 bps on July 28.

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