Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.
Neville Mandimika: And I'm Neville Mandimika, from the Emerging Markets Credit Strategy Team, with a focus on CEMEA (Central and Eastern Europe, Middle East and Africa).
Anlin Zhang: And I'm Anlin Zhang, U.S. credit strategist.
Andrew Sheets: And today on the program, we're going to talk about high yield bonds in the U.S. and emerging markets – and why we think emerging markets, or EM, in many cases offer better opportunity.
It's Friday, March 21st, at 2pm in London.
Anlin Zhang: And it's 10 am in New York.
Andrew Sheets: So, Neville, Anlin, it's great to talk to you, and I want to talk to you about a recent report that we all wrote looking at the market for high yield bonds in both the U.S. and emerging markets. In some ways, these two markets are similar. Both represent bonds with ratings below investment grade, both are denominated in U.S. dollars, and both offer more elevated yields.
But they're also quite different. The U.S. high yield market represents lending to companies in the United States. The EM market, for our purposes, represents lending to countries. So, Neville, that's where I'd like to start. When you think about that risk of lending to countries that carry lower ratings, some of the key metrics that you look at to determine if you're being compensated for that risk?
Neville Mandimika: We look at three distinct factors. The first one being fundamentals, including credit ratings as to whether they're getting worse or better. We also look at so called technicals, which show you how much a country needs to issue and how investors are already positioned in a country's sovereign debt. And then finally, valuations, what investors are being paid to take on that risk, and that is often presented in yields, spreads, and sometimes cash prices.
Andrew Sheets: And so, Neville, obviously the emerging market high yield sovereign space covers a lot of different countries that are dealing with a lot of different issues. But if you had to generalize over all of those three factors, how do they currently look?
Neville Mandimika: On the first point of fundamentals, I'll say since the COVID pandemic, we have seen a steady improvement in debt and fiscal ratios as countries have sought to create some room in order to be able to absorb future shocks. So, the so-called fiscal room. And they've done this in a number of ways; chief amongst them being, you know, going to, to the International Monetary Fund in order to create a sustainable fiscal framework.
That said, the work is not yet done. Debt levels are still quite high, relative to history; and expenditures are still outpacing revenues by some margin. But the overall direction, and I think this is the point to stress – the overall direction is positive.
Hence, we see a number of high yield countries with positive outlooks from the three major rating agencies. And Andrew, on the second point of technicals, I think this is where EM, the selling point is really quite strong. So, with fiscal improvements steadily happening, the need to raise a lot of debt has left us with the view that EM issuance will only see a 7 per cent year-on-year increase, which is quite small relative to history and relative to the U.S., which I'm sure Anlin will touch on.
This is quite positive. As demand relative to supply should remain in a steady balance, allowing for yields and spreads to maintain somewhat of a downward trajectory in line with our 2025 forecast. And then lastly, on the point of positioning, I would say EM high yield is actually not that over-owned by EM dedicated investors with allocations being in line with history. And this partly explains the resilience of EM high yield so far this year, despite headlines, which I'm sure you'd agree have been fast and furious.
Andrew Sheets: So, Anlin, kind of asking similar questions to you. As you look at U.S. high yield, how does the fundamental, the supply and demand, and valuation backdrop look in that market?
Anlin Zhang: In U.S. high yield. We find agri-fundamentals are holding up despite high rates. Earnings are on the path to recovery, with double digit earnings growth rebound expected by the market this year. However, dispersion across ratings is high, with the lower quality CCC cohort seeing weaker trends and being vulnerable in a higher for longer rates backdrop.
Now, in terms of technical. Technicals are less favorable in U.S. high yield versus the EM high yield market. On the demand side, we believe strong demand tailwinds can persist, with high rates and attractive all in yields. On the supply front, though, we forecast issuance increase more year-over-year in U.S. high yield at around 40 per cent year-over-year versus a more modest increase in EM.
As issuance picks up, we expect supply and demand to come into better balance in 2025, but this would be less of a positive technical for high yield investors. In terms of valuations, U.S. BBs and single Bs trade tight relative to history, but we believe spreads can stay near current tight levels through year end.
We think the setup for credit is healthy, with corporate fundamentals holding up and demand strong as mentioned. However, risks to the downside have recently come up with higher and broader tariffs and layoffs in the government, which imply weaker growth in the U.S. and stickier inflation. Despite this, the revised outlook from the econ team still suggests a decent growth environment for our market, but we acknowledge that a further slowdown will challenge the resilience of U.S. credit.
Andrew Sheets: So, kind of putting that together, we have a market, an emerging market high yield where ratings trends, those fundamentals look a little bit better. Where the relative supply and demand balance could also look a little bit better. And where relative valuations of EM high yield relative to U.S. corporate high yield are also pretty favorable. Three things that all seem to be moving in a favorable direction towards EM high yield.
But Neville, one concern that comes up in some of these conversations is the tariff backdrop, the trade backdrop. How do you think about emerging market high yield in the context of some of those risks?
Neville Mandimika: Yeah, I mean, it's certainly been a huge conversational point with clients, as you can imagine, as the reality is that we have to do a lot of permutations right, in terms of, you know, what tariffs are going to look like, over the next few weeks and months ahead. And I'll broadly classify the impact as coming from two direct channels. So, the direct impact and then the indirect impact.
So, from a direct standpoint, it'll be very country specific, similar to what we saw with Mexico, a few weeks ago. Fundamentally, you would imagine that, you know, if tariffs were to suddenly go up this would affect exports and ultimately economic growth.
Where EM high yield, I think, is an overall sub-asset class, where it could get affected is through the indirect channel. So, if, for example, we were to see a massive ramp up in tariffs in a way that causes fears of U.S. recession – and the Fed has to suddenly start cutting rates aggressively – EM spreads would struggle very much to hold up well in that environment. And as you can imagine, market access for some of the lower-rated EM high yield countries would struggle to issue, you know, debt at fairly reasonable levels. And that access would quickly go away.
So, for as long as tariff increases are gradual, and in a somewhat predictable way, we think that EM holds up well. And to put it differently, if I can borrow your phrase, Andrew, EM does love moderation as well. So, for now, we think that U.S. money managers should continue to position in selective BB credits where fundamentals are okay. Tariff exposure is potentially more minimal, valuation present as cheap, and liquidity in cash and CDS curves, is quite high.
Andrew Sheets: So, Anlin, it's also fair to say that the tariff story matters for the U.S. high yield market. Where do you think the highest exposures could be?
Anlin Zhang: Tariffs are a big story for U.S. consumer retail. Our credit analyst, Jenna Giannelli, views specialty retail as most at risk and less so for department stores and brands. For U.S. high yield in aggregate, sectors with high exposure to tariffs on China have a rather limited representation in the U.S. credit market. Top-down sector analysis done by our equity strategist shows the top three sectors with meaningful exposure are consumer discretionary, consumer durables, and apparel and tech hardware. These account for only around 5 per cent by market value in the U.S. High Yield Index.
Andrew Sheets: So just putting this all together, we entered this year at Morgan Stanley thinking that U. S. high yield would hold up pretty well in the first half of this year with maybe a more challenging second half of the year – as U.S. tariff policy started to escalate.
And even though our base case is still that spreads stay relatively low, it's clear that the risks to this view are rising as U.S. policy uncertainty has gone up, and our forecasts in the U.S. for growth have gone down. In that context, we're looking out for markets that might offer better risk reward, and we think that emerging market high yield sovereigns could qualify.
Neville, thanks so much for taking the time to talk.
Neville Mandimika: Thanks Andrew.
Andrew Sheets: And Anlin, thanks for taking the time as well.
Anlin Zhang: Thank you.
Andrew Sheets: And to our listeners, thanks for listening. If you enjoy the show, leave us a review wherever you listen, and share thoughts on the Market with a friend or colleague today.
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