(Arnav Barry)
Investors have been divided over the prospects for emerging market debt since the Covid-19 as many developing countries now face tough economic decisions about how to rebuild after months of lockdown. Government bonds in frontier markets now have a greater risk of default due to large debt burdens taken on by countries, but also offer a potentially large return if the uncertainty around the economy is judged correctly. Quantitative Easing (QE) which raises bond prices and flattens the yield curve has also begun to travel to some countries, as central banks attempt to provide stimulus to kickstart many industries in the developing world. This has lowered yields from their March highs as the market has priced in the potential economic expansion that some countries could see in the next 2-5 years. The Philippines has been an outstanding performer in this asset class due to its strong financial sector and low debt, which makes it best positioned to recover, as compared to other emerging markets such as India or Vietnam. This makes it likely that Filipino Bonds will present a good investment opportunity in both the short and long term.
Yield Curve and Spreads Analysis
The yield curve looks promising for the Philippines as the steady fall in yield from 1 month , matched by rise in prices for 2Y of 0.99% and 10Y of 4.56% suggests a strong economic outlook in the medium term, as investors have significantly increased their holdings of Filipino Bonds. The steepening of the spread between the USA and Philippines also implies steady economic expansion over the long term as higher inflation begins to be priced in, making the probability of default extremely low, showing that they offer a good long term investment. This is reinforced by the decrease in the value of 5 year Credit Default Swap from 100.290 to 61.900 (-38.27%) which indicates confidence in the Filipino government’ ability to repay debt. This strong economic outlook puts Filipino bonds in a good position to outperform other Asian markets.
In contrast the spread for Indian government bonds over 2Y is 221.9bp higher than the Philippines which demonstrates the looming problems their economy faces as they struggle to control coronavirus. The higher spread indicates a greater probability of default as compared to Filipino bonds, as investors want to be compensated for the greater risk they are taking on. Furthermore the 2 small humps in the Indian yield curve often signal an economic slowdown as it shows that investors expect interest rates to be higher in 8 years than 10 years. This suggests that there is great uncertainty about the future of the Indian economy, making it a risky investment amongst Asian emerging markets. This is also implied by resistance in the value of 5 year CDS, as they refuse to fall below 100, demonstrating the lack of confidence in the government’s ability to be fiscally responsible.
In contrast Vietnamese bonds offer a much more promising outlook with the lowest spreads amongst Asian emerging markets on US bonds at just 62.4bp for the 2Y bond. The steeper yield curve from 2Y to 10Y shown by a spread of 206.1bp as opposed to 88.2bp for the Philippines indicates a strong economic expansion in the medium term as investors begin to price in higher inflation expectations through increased economic activity. Yields for Filipino and Vietnamese bonds are quite similar at 2.781% and 2.844% respectively which suggests that investors believe both countries are set to emerge strongly from the recession. The higher spreads in Filipino bonds may therefore indicate that they are less valuable than Vietnamese in the market. However macroeconomic analysis shows that the Philippines are still a viable opportunity as a result of their financial sector stability.
Macroeconomic Outlook
Quantitative Easing (QE) will be a huge determinant in emerging market bond prices in the future as other central banks have begun to adopt the policy. The Philippines have participated in a 3 month repurchase agreement worth 300bn pesos which suggests that the central bank is not averse to using unconventional policies. This could provide a good investment opportunity as bond prices will be inflated, as banks increase demand through buying up securities. The lower central bank rate of 2.25% as compared to 4.50% in Vietnam means that the Philippines are more likely to use QE to stimulate the economy as they have less room to reduce rates before hitting the effective lower bound. This could mean that Filipino bond prices experience a greater surge due to repurchasing schemes by the central bank, suggesting that they could be undervalued as compared to Vietnamese bond yields. Although the RBI has also been buying from primary markets, the risk of default by governments is still very real which makes Indian bonds a less desirable investment, especially as COVID-19 cases continue to rise all over the country.
The Filipino government also has a very sustainable fiscal outlook which positions it well to outperform other emerging markets. An external debt to GDP ratio of 24%, half that of Vietnam’s makes it less vulnerable to capital flight or currency crises, especially given the large FX reserves that can last over 12months. This makes the Philippines unlikely to suffer economically in the short term and subsequently, they should experience a strong rebound in the medium term which makes government bonds a less risky opportunity than priced by the market. Furthermore, being a net oil importer will mean the country benefits greatly from falling oil prices, another factor which makes expansion likely in the future. The country’s handling of the coronavirus epidemic has also been sturdy, as they faced their first 24 hour period without deaths for over 3 months. This is likely to affect markets and puts the Philippines in a much better position than other Asian emerging markets such as India, who have yet to hit their peak.
Prediction
Based on yield and spread analysis Filipino bonds seem to be undervalued by the market, suggesting they are a good investment to buy. In the short term bond prices are likely to rise as the central bank continues with its scheme of QE, which will be on a greater scale than most Asian countries. As the economic outlook begins to look better for the Philippines than previously expected, emerging markets investors are likely to divert their funds from other Asian countries such as India, which should increase the demand for Filipino bonds. This is due to the strong fiscal and macroeconomic base which the country has, allowing it to continue to grow steadily in the medium term. This will also translate into a good long term investment opportunity as the country has one of the most sustainable debt burdens amongst emerging markets, making the risk of default very low.
Definitions
Quantitative Easing – Policies used by the central bank to buy up lots of government bonds and securities in the market, providing liquidity and lowering yields to stimulate the economy.
Yield – The return an investor receives from a bond. The price and yield are inversely related since if a bond is trading below par, the coupon received will be a higher percentage of the initial investment and vice-versa
Spreads – The difference between the yields of 2 bonds compared over time. Generally, spreads are compared to extremely safe bonds such as the Bund or T-Bills. This spread gives an idea of how risky the bond is perceived to be.
Yield Curve– Graph showing the yields to maturity for bonds of different durations. Generally, the yield curve is steadily upward sloping as investors expect to be compensated for their liquidity premium and risk of default over a longer period of time. Inverted yield curves can often signal a recession.
Credit Default Swap – A type of derivative based on an underlying security. One party pays the other a steady stream of money but will be compensated back if the issuers of the underlying security defaults on their debt. A rise in the value of CDS can indicate that the probability of default is perceived to be higher.
References
Ft.com. 2020. Debt Investors Bet On Emerging Markets As ‘QE’ Begins To Travel. [online] Available at: <https://www.ft.com/content/779b7776-cfef-4d53-9295-b4493559dc71> [Accessed 9 July 2020].
Investors’ Corner. 2020. Emerging Market Debt – Appearances May Deceive – Investors’ Corner. [online] Available at: <https://investors-corner.bnpparibas-am.com/investing/emerging-markets-debt-appearances-may-deceive/> [Accessed 10 July 2020].
Ft.com. 2020. Investors Should Not Shrink From Frontier Emerging Markets. [online] Available at: <https://www.ft.com/content/10104ada-be47-4861-aba1-e8216a3651b9> [Accessed 8 July 2020].
World Government Bonds. 2020. World Government Bonds – Daily Updated Yields. [online] Available at: <http://www.worldgovernmentbonds.com/> [Accessed 9 July 2020].
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