Asia-Pacific sovereign and corporate borrowers are at an increasing risk of default, which leaves regional institutional investors with the prospect of having to take sizeable markdowns to some of their debt investments.

On Wednesday (May 15) Moody's said that its global emerging markets Liquidity Stress Indicator (LSI) reached 23% in April. That is the weakest level on record and much higher than the long-term average of 19%. A higher percentage points to weaker liquidity and a greater likelihood that defaults will rise amid ongoing coronavirus-related disruption and market uncertainty.

Its report followed one by Fitch Ratings the day before which predicted that sovereign defaults look likely to set a record in 2020. Emerging market sovereigns such as several African nations, Iraq, El Salvador and Sri Lanka look especially vulnerable.  

What is a particular worry for Asia-Pacific institutional investors is that the weakening of Moody’s LSI has occurred in large part because borrowers in emerging market countries in the region have become more vulnerable to a liquidity crunch.

“The EM Asia-Pacific LSI has gradually increased to 40% in April 2020 from 33.1% in September 2019,” said Annalisa Di Chiara, a senior vice president at Moody's in a media release, adding that the Asia-Pacific LSI was the “most influential” on the overall ranking.

She noted that the ongoing impact of the coronavirus on economies across the globe has raised debt refinancing risks, particularly for high-yield borrowers that need to repay debts during this year and next.

The outlook for such borrowers is causing a downgrade in credit rating outlooks. Moody’s reports that ratings with negative outlooks or those on review for downgrade climbed to a record high of 40.1% in April. More concerningly, the ratings agency said that it predicts the trailing 12-month junk bond default rate for emerging market companies to rise from 2.2% in March to between 7.8% and 11.2% by the end of the year.

While those weak sentiments have left distressed asset investors anticipating many investment possibilities, high-yield bond buyers with an exposure to emerging market credits could suffer sizeable losses, if this forecast is anywhere near accurate. 

That said, the danger lies mostly with junk-rated companies. Moody's noted in a separate report that non-financial borrowers in Asia had $266 billion of bonds maturing from May 1 through to the end of 2020 and a further $303 billion in 2021, but that investment grade companies account for 70% of this amount and should weather the more difficult conditions. 

EMERGING DEFAULTS APPROACHING

Typically, many conservative asset owners such as pension funds and life insurance companies look to invest mainly in sovereign bonds when they delve into sub-investment grade territory.

But Fitch Ratings notes that the global nature of the coronavirus pandemic leaves many of these at risk too.

The rating agency pointed out that Argentina, Ecuador and Lebanon have already defaulted on sovereign debt in 2020, which equals the record high of three defaults by Fitch-rated sovereigns, last seen in 2017.

That accounts for quite a few junk-rated sovereign borrowers. Fitch noted that it downgraded 29 sovereign borrowers in the first four months of the year, eight of which are in the weakest range of CCC or lower. And it has changed the outlooks of another 28 to negative, up from four at the end of last year. Now, 29% of all its sovereign ratings are B or weaker.

It added that “the sovereigns most exposed to the coronavirus and oil price shock are those with generally weak credit fundamentals, such as high government debt and weak policy credibility; and those reliant on commodity exports or tourism, or with large external financing requirements, foreign-currency debt, prior hot-money inflows and low foreign-exchange reserve buffers”.

Sri Lanka is the weakest-rated in Asia, holding a B- rating with a negative outlook from Fitch. The agency notes that most CCC or lower sovereigns are based in Africa and that the average default rate for such lowly rated sovereigns was 26.5% between 1995 and 2019, with a cumulative five-year default rate of 38.5%.

Sovereign defaults since 2001

 

Fitch notes that sovereign defaults are fairly rare. It has recorded “just 23 defaults of rated sovereign across 14 countries since it started its sovereign coverage in the mid-1990s”. But sovereign defaults have picked up since 2016, and current conditions make failures to keep up with debt payments far more likely.

For asset owners that have sought to put more money into emerging market and sovereign bond funds, to earn a bit more yield, the coming months could prove a costly experience.