Rally in commodities is not priced into emerging market corporate bonds

Russia’s invasion of Ukraine is intensifying the selling pressure on emerging bond markets. Among corporate bonds, this is not just the case for affected companies, but across the entire universe with price action becoming increasingly indiscriminate. The recent correction is, thus far, the culmination of a period of weakness that has prevailed since September. Net outflows of over USD 15bn from the hard-currency corporate bond asset class have pushed bond prices lower, catalysing a steady rise in bond yields. The main reason for price declines in recent months has been fears of a far more hawkish Fed monetary policy and the resulting rise in interest rates. In addition, problems in the Chinese property and technology sectors have persistently worsened.

On the one hand, this tough market environment and negative news flow call for caution. Conversely, there are also opportunities for investors with a long-term investment horizon. We see many cases where company fundamentals do not warrant such substantial repricing. The undervaluation is particularly evident in the commodities sector. Structural deficiencies (due to underinvestment over the past few years) and the new geopolitical reality have pushed commodity prices higher, and many factors suggest that the rally will last into the foreseeable future.

The commodities boom is likely to boost economic growth
Many emerging markets are net commodity exporters. In some Latin American countries, raw materials still account for more than two-thirds of export volumes. In Colombia, for example, around 40% of export earnings are derived from oil. Although reforms have been put through to diversify these economies, most of their growth is still driven by these commodity exports. Higher prices boost the entire value chain, and we therefore expect upgrades in economic growth forecasts in many exporting countries. This assessment is already reflected in stronger currency and equity markets in Latin America.

In stark contrast, risk premiums on high-yield corporate bonds in Brazil, Peru and Colombia have increased by 50 or 60 basis points since the Ukrainian war broke out. Investor nervousness can be traced in part to fears of a leftward political tilt in these countries. Leftist presidential candidates are leading in the polls ahead of elections in Columbia and Brazil. However, the examples of Andrés Manuel López Obrador, in Mexico, and Pedro Castillo, who was elected last year in Peru, have shown that the democratic checks-and-balances work well in these countries, as legislatures have passed only very moderate policies. A political premium is likely to remain priced in for some time to come, but we see no reason why rising commodity prices should be completely ignored, believing that this can be explained only by irrational sentiment.

Bonds under pressure, despite solid fundamentals and a positive outlook
Commodity producers are benefiting even more directly from higher prices. We expect almost all of the balance sheets of natural resources providers to strengthen throughout the current year and, as a result, their risk premiums to recede. Even so, credit spreads of high-yield corporate bonds in the oil & gas and metals & mining sectors (excluding Russia and Ukraine) have widened by about 100 basis points since mid-February (as measured by the J.P. Morgan CEMBI Broad Diversified HY+ Oil & Gas and Metals & Mining indices as of mid-March). This includes, for example, a Colombian gold producer whose yield has widened from 7% to 10%, and a Brazilian oil-exporter operator whose 10-year bond has dropped by 10 points. In both cases, we are not aware of any change in fundamentals that would warrant these valuation distortions.

As long as this selling pressure persists, we expect there to be more buying opportunities that long-term investors can exploit selectively and gradually position themselves in the most promising companies in each emerging market segment.