This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
A recent media inquiry fielded by the author dealt with the possibility of fallout from July's sell-off in bonds issued by companies based in China. The sharp drop in these issues, which are heavily focused in the real estate sector, may have raised fears of a repeat of the global market response to the events recounted in the following excerpt from the summary of a book titled Asian Contagion:
In the summer of 1997, thirty years of economic boom came crashing back to earth. The reality of unrestrained speculation, inefficiently regulated currency exchange, banking instability and bad loans have struck [countries such as] Thailand, Indonesia, Korea, and, finally, Japan, casting a shadow of uncertainty on a region recently to the fore in the world economic system.
The Asian crisis triggered a global equity mini-crash on Oct. 27, 1997. That day saw a 6.9% plunge in the S&P 500. As for credit market impact, the ICE BofA US High Yield Index's option-adjusted spread widened by 26 basis points.
It is not possible to demonstrate that the current troubles in Chinese corporate high-yield bonds cannot spill over to the U.S. market. At the same time, there are precedents for major upheavals in the emerging markets debt remaining geographically contained. Investors must consider those data points in assessing the risk posed to developed-country high-yield debt by upheaval in the Chinese property sector.
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July's global rise in risk premiums on speculative-grade debt was marked by wide regional differences. The ICE BofA US Emerging Markets Corporate Plus Index's OAS ballooned from +529 bps on June 30, 2021, to +607 bps on July 30, 2021. That 78 bps widening compared with OAS increases of 28 bps on the ICE BofA US High Yield Index and 17 bps on the ICE BofA Euro High Yield Index.
The emerging markets sell-off was concentrated in the issues for companies based in China. Their mean price change during July was -6.25 points. By contrast, the mean price change for issues in the group from companies based outside of China was -0.55 points. (The medians were -3.84 and -0.31 points, respectively.)
Among the China-based issuers, a focal point of the decline was the EM index's largest Asian issuer, China Evergrande Group. Between June 22 and Aug. 2, the property developer's ratings fell from B/B2/B to CCC+/Caa2/CCC, with Moody's and Fitch both downgrading the credit twice. The ratings reductions reflected Evergrande's weakened liquidity position and reduced access to funding, along with expected further declines in gross margin.
Through July 30, Chinese issues within the Bloomberg Barclays Index posted a -7.3% year-to-date total return. The CCC subset of those issues returned -46.3% over the period. By contrast, the ICE BofA CCC & Lower US High Yield Index return through 2021's first seven months was 9.00%.
Historical examples of non-contagion
There is no shortage of historical examples of emerging markets crises disrupting financial markets in more developed countries. In addition to the previously mentioned 1997 Asian crisis, we can point to the 1998 Russian crisis and the Latin American debt crisis of the 1980s. However, it does not automatically follow that the recent sell-off in Chinese corporate bonds will spread to the developed world. Indeed, the price changes cited above suggest that the fear and loathing did not even spread to other emerging markets, at least not to any significant extent. Along with examples of crises that spread, the financial history books contain noteworthy examples of those that didn't.
In August 2019, bonds of the least creditworthy emerging markets countries became hot potatoes in the face of slowing global growth and mounting trade tensions. Indonesian and Indian issues came under particular pressure as the ICE BofA US Emerging Markets Corporate Plus Index's OAS widened by 78 bps. In that same month the ICE BofA US High Yield Index's OAS tightened by 31 bps.
Argentina's debt repayment prospects were the key source of emerging market jitters in 2001, culminating in a suspension of interest payments by the Argentine government in December. In July, the EM index widened by 64 bps while the U.S. high-yield index tightened by 31 bps. The disparity was even greater in November, as the EM index widened by 61 bps while the U.S. high-yield index tightened by 73 bps.
These examples drive home the point that, depending on circumstances, global high-yield investors can respond in any of three different ways to an emerging markets credit crisis:
* Sell developed-country high-yield bonds and go to safer assets, on the premise that interdependency of emerging markets and developed countries' economies and financial systems will ensure transmission of the problems to the developed countries.
* Maintain developed-country high-yield exposure at existing levels.
* Redeploy money from emerging markets to add to developed-country high-yield, on the premise that the EM crisis will drive capital to the relative safety of developed-country speculative-grade debt.
In August's opening sessions, Chinese corporate bonds rebounded on perceptions that July's sell-off had dropped them to attractive levels. Within the ICE BofA US Emerging Markets Corporate Plus Index, these issues posted a mean price gain of 1.70 points through Aug. 4. Evergrande bonds gained an average of 6.46 points. Issues of other emerging markets companies in the index were also in the black, up an average of 0.14 points. (The medians were, respectively, 0.76, 6.45, and 0.02 points.) We may not have heard the last of troubles in the Chinese property sector, but so far, this episode is shaping up as a successor to episodes in which the crisis is contained.
Research assistance by Manuj Parekh and Weiyi Zhang.
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