Riskiest country debt left out of emerging-market renaissance

Even as the outlook brightens for emerging-market debt, bonds from a handful of the riskiest countries are being left behind. And there is little evidence that's about to change.

Dollar notes from nations ranging from Tunisia to Argentina and Lebanon to Egypt are handing investors steep losses this month, contributing the most to a 0.7% decline in the Bloomberg Emerging Markets Sovereign Index.

The laggards have weighed on the performance of an otherwise resilient group, which stands to benefit as inflation eases and central banks near the end of interest rate hiking cycles. While their problems vary, the underperforming countries stand out for their weaker credit markets and their over-reliance on support from multilateral lenders such as the International Monetary Fund.

"The countries that are under stress are clearly demonstrating a larger concern" for investors, said Joe Delvaux, a money manager in London at Amundi SA. "Some of the concerns can be predominantly focused on their debt sustainability, while others again also face political issues."

Some of these nations, including Lebanon, are already in default, and investors weighing the likelihood of others following suit came out of the spring IMF meetings in Washington this month with few reassurances. The gathering — a barometer for whether bailout deals can be reached — showed that governments and the mulitlateral lender remain deadlocked in many cases.

"We don't come away from the meetings with more optimism" for low-rated bonds, Morgan Stanley & Co strategists wrote in a note. Discussions were on the "bearish side" around several deals, including Egypt and Tunisia.

Bonds from those countries have lost as much as 9% this month, while debt from Lebanon, Senegal and Kenya posted losses in mid-single digits, according to data compiled by Bloomberg.

Several governments are running out of time to fix their fiscal imbalances and win IMF programs. Egypt is facing an acute shortage of wheat, with a little more than two months of stocks, as a currency crisis rages. Kenya had to delay salaries to public-sector workers, while Argentina's central bank raised rates by 300 basis points to 81% on Thursday to try and contain rampant inflation.

"A lot of the countries need the money now," said Mark Bohlund, a senior credit research analyst with REDD Intelligence. "Otherwise, they'll have to borrow at very high rates, both locally and externally. If they lock up the current high market rates, it is only going to worsen the problem."

In a twist, the worst performer, Argentina, received another $5.4 billion from the IMF at the end of last month, and some investors are optimistic upcoming elections will bring in a more market-friendly government.

Still, with near triple-digit inflation and falling international reserves weighing on the serial defaulter, the country's bonds have slid around 12% this month.  

For those willing to take on the risk, there's enormous upside in betting on the most distressed bonds.

Many of the riskiest countries trade below the value investors could expect to receive in a debt restructuring. The average recovery value on defaulted sovereign bonds over the past four decades is 50%, though there have been recoveries as high as 95%, said Elena Duggar, Moody's chief credit officer for the Americas.

History shows investors have been rewarded for buying back the debt quickly once there's any incremental progress on talks with lenders. Bolivia is a case in point. The country's debt was one of the worst performers in emerging markets earlier in April, but rebounded last week on signs it will get multilateral financing support.

Still, in most cases, the market is left waiting for a catalyst.

In Tunisia, for example, bondholders could expect an average recovery rate of 74 cents on the dollar, Morgan Stanley & Co International analysts indicate. Bonds due in 2026 currently trade around 49 cents, according to data compiled by Bloomberg.

The government, however, has not made progress on negotiations with the IMF.

"The protracted stalemate with the IMF makes us less optimistic," analyst Neville Mandimika wrote in an 19 April note, adding the bank moved the credit to a "dislike stance."

"If this persists, Tunisia could fall into arrears," he said.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.