Russia's invasion of Ukraine has created a tragic humanitarian crisis while roiling financial markets, clouding global growth prospects and intensifying inflationary pressures. The war has also put emerging markets (EM) under a magnifying glass, especially as investors evaluate the impact of the West's response to the war and keep a close eye on China.
Elisabeth Bakarich, CFA
Senior Vice President and Portfolio Manager—Emerging Market Corporate Debt
Gary Zhu, CFA
Senior Vice President and Director—Insurance Portfolio Management
Earlier this year, we noted the possibility that renewed volatility in 2022 would create dislocations—and opportunities— for insurance investors to reposition their portfolios to take advantage. EM was one potential avenue of opportunity we noted, and we believe that insurers, as long-term investors, are in a unique position in this space.
EM Has Been Holding Up Well Versus Developed Markets
Historically, EM has performed well versus developed markets (DM); away from the eye of the Russia/Ukraine storm, this remains true. EM corporate spreads held up better than US investment-grade (IG) spreads until recently.
Our analysis suggests some dislocation between EM and IG corporates, and we expect the spread difference between them to widen. In sovereign bonds, higher-quality EM issuers have held up, but the BBB-rated cohort has started showing broad signs of weakness. We see this pocket of spread widening as an opportunity for insurers to benefit, and it highlights the importance of a platform that can analyze relative value across both asset classes and sectors.
Chart 1: Relative Widening between EM IG and US IG presents opportunity to add
The Ratings Perspective: EM Risk Profiles Are Comparable to DM
Ratings migration is a key risk factor when evaluating opportunities for insurers, especially with markets more volatile. Corporate ratings migration in EM compares favorably to that of DM in the AA, A and BB. Downward migration in BBB EM credit, the largest rating category based on outstanding debt, is only slightly higher than that of DM. This historical rating experience is the likely reason why BBB EM corporate spreads have widened recently versus comparable US IG corporates, even while other rating categories have held up relatively well. In general, the risk profile of the EM corporate sector isn't markedly different than that of DM corporates, and wider EM spreads could be a more attractive entry point for insurers.
Chart 2: Comparison of EM and DM Rating Transitions
|One-Year Rating Transition|
|% of Cohort Downgrade From/To||EM||DM|
|AA to A||7.6%||7.7%|
|A to BBB||4.5%||5.0%|
|BBB to BB||4.4%||3.5%|
|BB to B||4.7%||6.6%|
|Two-Year Rating Transition|
|% of Cohort Downgrade From/To||EM||DM|
|AA to A||14.4%||13.9%|
|A to BBB||8.2%||8.8%|
|BBB to BB||7.5%||5.7%|
|BB to B||7.0%||9.8%|
|Source: S&P EM Rating Study—covering rating changes over 1997–2019 period, corporates only.|
Geopolitical Risks Are Concentrated in Specific Regions and Sectors
In this latest bout of geopolitical turmoil, a forward-looking view on EM risk is equally as important as a historical perspective. The situation remains fluid, but with the exception of a handful of issuers and countries, most have low direct risk to the situation in Russia and Ukraine.
We expect positive indirect impacts on producers of metals, oil and gas, and protein processing. As for negative indirect impacts, those most under pressure are select names within the chemicals, consumer and utility spaces; in our view, negative impacts should be low for most other sectors. Diverging fundamentals, especially with heightened geopolitical tensions, makes active management even more important.
Optimizing Your EM Debt Allocation
We see EM as an extension to core insurance portfolios because of its income-enhancing qualities and potential for higher risk-adjusted returns than DM over time. Because EM local currency and rates are often highly volatile, we typically point to the hard-currency space when discussing the asset class with insurers looking to begin or add to an allocation. Plus, depending on the currency in which insurers write their policies, sticking to EM hard currency can help avoid the need for complex hedging programs, which at times can be operationally challenging considering the variety of EM currencies.
The EM debt universe has grown significantly over the past decade- plus. The number of corporate issuers alone, for example, has soared from less than 400 in 2009 to more than 1000 by year-end 2021. This broader universe, when combined with the flexibility to take advantage of the full opportunity set, helps us design EM insurance portfolios that are highly diversified across countries, sectors and issuers.
Overall, a well-diversified investment-grade EM allocation can help boost yield and deliver strong returns to core portfolios. Despite the overhang of risks stemming from the war in Ukraine, we still advocate for a strategic allocation, making tactical adjustments as we identify opportunities and market dislocations.
Chart 3: EM default rates stack up favorably versus DM*