Lazard Insights

The Great Emerging MisconceptionDarren Madden, CFA, Senior Vice President, Client Portfolio Manager

Summary• Markets may have overplayed the threat of

sovereign emerging markets debt defaults. Although the pandemic will challenge emerging markets countries, only a handful are at a high risk of default in our view.

• International financial institutions and negotiation procedures now in place tend to quickly resolve emerging markets defaults when they do occur and provide the foundation for sustainable debt restructuring.

• The widespread misperception about the risk defaults pose to emerging markets debt has created compelling alpha potential—both over the longer term for investors who can afford to wait for the post-default recovery and more immediately for the asset class in general, thanks to the excessive pessimism priced into current valuations.

Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.

The COVID-19 pandemic, for all its terrifying singularities, has roused one well-worn hobgoblin from its slumber: the solvency of emerging markets sovereign debt. Like most irrational fears, this one sprouts from a grain of truth. The pandemic will doubtless deal the emerging economies a heavy blow, as it will the developed economies. They will face the declining growth rates and expanding fiscal deficits.

Giving Credit where Credit Is DueThe emerging economies, by and large, have entered this crisis well prepared to cope. Begin with the fact that emerging markets defaults take up a far larger share of media mindspace than the facts warrant. Since the turn of the century through the global financial crisis to our present moment, there have been only 14 sovereign defaults—most of which have been by smaller countries—an average of less than one each year. The emerging markets sovereign default rate will in all likelihood rise as a result of the pandemic slowdown—to 3%, according to consensus—but should still trail well behind the expected US high yield default rate of 8% (Exhibit 1).

As a group, the emerging markets have taken advantage of historically low borrowing costs, but, thanks to growing GDPs, they have managed to keep overall debt-to-GDP ratios to around 50%, less than half the ratios of such developed market stalwarts as the US and Japan. The so-called middle-income emerging markets1 accrued much of the new debt. They issued it to a great extent in locally denominated currencies, which gives them greater flexibility

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in servicing their foreign currency-denominated liabilities. As a group, the middle-income emerging markets benefit from ample hard currency reserves, access to financing, independent central banks, and resourceful policymakers.

While the overall picture could be considered positive, the investable emerging markets universe consists of more than 70 separate economies. As in any group portrait examined in detail, a few members look less fit than the rest—our outlook, remember, does call for the annual emerging markets sovereign default rate to rise to 3% from the average rate of 0.7% since 2000. Several symptoms could flag the declining health of an emerging markets sovereign credit:

• A debt-to-GDP ratio greater than 60%

• A ratio of short-term debt to hard currency reserves greater than 130%

• A ratio of public debt-to-revenue above 215%

• An inflation rate greater than 10%

• Elevated political uncertainty

Defaults also tend to be more common in countries with smaller economies, economies dependent on commodity exports, and countries with pegged currencies. Such factors make a sovereign credit hostage to exogenous shocks. The shock might be global in nature, as it was for Argentina in 2001 when commodity prices collapsed. Or it might be idiosyncratic, as when Russia’s annexation of Crimea pushed Ukraine over the brink.

What Happens When a Default Happens?Simply put, when a sovereign debtor fails to meet an interest or principal repayment deadline, creditors look to recover what they can, and economies, belts already tightened by the conditions that created the default, look to restructure and move on. Unlike corporate bankruptcies, sovereign restructurings lack a formal, step-by-step liquidation process. In its place, debtor and creditors negotiate a settlement, each side brandishing all the tools of game theory to secure a favorable—or at least less painful—outcome.

Credit institutions with a global mandate, like the International Monetary Fund (IMF), that typically participate in sovereign emerging markets loans have a vested interest in bailing out a troubled sovereign. They seek to contain the default and maintain the smooth and liquid functioning of the global bond markets. This objective has helped speed negotiations; so has the trend toward collective action clauses in debt instruments, which prevent holdouts from scuttling a proposed settlement. As a result, and contrary to the popular misconception, sovereign debtors and international creditors conclude workouts in fairly short order nowadays. Take the current Argentine crisis by way of example: The nation failed to meet its May interest payment, and as we publish this piece in June a settlement seems forthcoming. In 2001 when Argentina defaulted, it took the parties 54 months to come to an agreement.

Soft Defaults and Hard Tolstoy’s 19th-century observation about families—happy families are alike; each unhappy family is unhappy in its own way—could, with the alteration of a half-dozen or so words, apply equally to an analysis of current emerging markets sovereign defaults (Exhibit 2). Yet the fact that they have all defaulted does suggest some commonality. The sovereigns have defaulted either because they didn’t have either the ability or willingness to service their debt. For those countries in the former category, most lack the liquid assets to meet their payments or, more seriously, they lack sufficient assets altogether and are facing the prospect of longer-term insolvency. The overriding objective in either case is to make the defaulting sovereign’s debt burdens sustainable—bringing them down, in other words, to a level that the economy is able to service and the populace is willing to repay.

Creditors can address illiquidity by extending the maturities on the outstanding debt or reducing the coupon payments. Either measure or both in combination can reduce the drain on a sovereign’s ready assets and bolster its ongoing ability to meet current obligations. Insolvency, on the other hand, may require some form of debt relief—and impose more pain on the creditors, since it invariably implies a loss of their principal (Exhibit 3).

Exhibit 1Defaults: US High Yield Dwarfs EM Sovereign Debt

Default Rates in EMD vs. US High Yield

0

3

6

9

12

‘20F‘19‘18‘17‘16‘15‘14‘13‘12‘11‘10‘09‘08‘07‘06‘05'04’03‘02‘01’00

(%)

US HY Avg

EMD Avg

US High Yield

EMD Sovereign

As of 31 May 2020

Source: Lazard, JPMorgan

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In either case, once a sovereign has reached a workout agreement, it has touched bottom. It has passed through the economic contraction that brought it to default in the first place and by renegotiating its debt it has put in place the foundation for a restoration of its credit and a return to the debt markets.

The Good Story behind the Bad HeadlinesAll told, the specter of defaults, far from frightening, makes emerging markets debt one of the most compelling opportunities in these turbulent times in our view. History has shown that investors with reasonably long time horizons who take a position in defaulted debt can realize sizeable gains. That potential stems from the fact that the default risk of a newly restructured bond is low. In addition, a debt exchange is sometimes tied to an IMF agreement, often linked to prudent economic policies, and may help unlock additional financing from other multilateral lenders.

In our analysis of sovereign defaults since 2000, we found that returns averaged in the high-teens for the 12-month period after the default announcement. That said, the range of outcomes has been wide. Investors in Ecuador’s bonds gained over 100% in the year after the country’s 2008 default, but an investor who bought Argentine bonds on the day of default in 2001 would have

Exhibit 3The Default Spectrum

Creditor Friendly Creditor Unfriendly

Debt Reprofiling Soft Default Hard Default

Assessment Factors

Reason for Default Creditor Friendly Creditor Unfriendly

Macro and Fiscal (Quantitative)

Liquidity Problem Solvency Problem

Government Intentions (Qualitative)

Willingness to Pay Ability to Pay

Key Focus of Negotiations

Financing Needs Debt Levels

Source of Debt Relief Maturity Extension, Coupon Reduction

Principal Haircut

Average NPV Loss 20% 60%

Source: Lazard

For illustrative purposes only.

Exhibit 2A to Z Current Restructurings

Current Bond Price ($)

Expected Recovery Value ($) Comments

Argentina 40 50 • The deadline for creditors to accept the government´s proposal has been extended several times.• An agreement is reportedly close and may include agriculture-linked warrants.• Neither side wants a protracted, hard default.

Ecuador 38 50–60 • Country has been a serial defaulter.• The government recently presented a macroeconomic update to investors.• Discussions with creditors are expected to begin in mid-June.

Lebanon 20 40–45 • Around 70% of eurobonds are held domestically, so the government can force local banks to accept write-downs.

• Lebanon still needs to create a credible fiscal austerity plan and engage with the IMF.• IMF has indicated that negotiations may be lengthy.

Venezuela 5 20 • Venezuela has been in default since late 2017 and has been mired in a state of crisis for many years.• The country has the world´s largest oil reserves, but is unable to monetize due to sanctions and

underinvestment.• Regime change is key to unlocking value.

Zambia 48 50 • The global health crisis and drop in copper prices finally pushed Zambia’s muddle-through strategy to the brink.• The finance ministry has indicated that it will seek to negotiate with creditors rather take unilateral action.

As of 15 June 2020

Certain information contained herein constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events may differ materially from those reflected or contemplated in such forward-looking statements.

Source: Lazard, Bloomberg, JP Morgan

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RD00199

Notes1 The World Bank defines the middle income emerging markets as those with annual per capita incomes between $1,000 and $12,500 in 2018.

Important InformationPublished on 26 June 2020.

Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.

The MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of 26 emerging markets country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. The index is unmanaged and has no fees. One cannot invest directly in an index.

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been down nearly 30% a year later. In the latter case, bond prices continued to decline after the default because the government adopted a tough negotiating posture against bondholders which effectively shut Argentina out of the global capital markets for several years.

The specifics and risks may vary, but based on current valuations, we anticipate returns in the debt of certain defaulted countries could exceed 50% over the medium term. Such troubled situations represent a very narrow slice of the emerging markets debt universe, concentrated among export- and remittance-dependent economies, and the IMF has made clear its intention to keep the slice narrow with the creation in April of a short-term financing facility to tide over creditworthy sovereign borrowers.

Despite such institutional reassurance, we believe the current level of emerging fixed income spreads implies an unprecedentedly high default rate of 6%, and assumes a very conservative recovery rate of 20%. That high default rate is two times greater than expectations and more than six times greater than historical averages. Weighing these factors, investors must judge whether emerging markets valuations today portend a sovereign default wave or imply compelling opportunity. Based on the resilience the bulk of the emerging economies has shown since the global financial crisis and the enhanced flexibility of global financial institutions and their negotiating positions, we line up on the side of opportunity.