Valuations in many parts of emerging markets are still attractive, though with EM default rates set to rise, there is a need for continued differentiation and credit selection, notes Barclays in a recent report.

Andreas Kolbe and team at Barclays in their April 23, 2015 Emerging Markets Weekly report titled: “Taking a breather” note the likely pickup in defaults in EM should not lead to systemic concerns.

Be selective in emerging markets HY space

The Barclays analysts point out that the HY and distressed share of the EM credit universe has grown thanks to adverse rating trends, geopolitical events, and a less favorable EM macro environment. However, the analysts note valuations in many parts of emerging markets are still attractive, with their preferred credits in the EM HY space include Venezuela, Argentina, Indonesian HY corporates and select Russian credits.

Kolbe et al. note with the vast majority of Russian issuers having lost their IG status, the IG share of the EM credit universe has dropped, essentially for the first time since 2005. They note beyond a mere migration of select EM issuers from IG to HY, spread dispersion within the EM HY universe has risen sharply, with a much higher number of EM issuers trading in distressed territory than in the previous years:

IG share of emerging markets credit

They also note emerging markets default rates had been relatively benign over the past few years until early 2015. Overall, the analysts believe EM default rates have remained low and broadly in line with U.S. HY. However, they caution that the benign default rates in emerging markets are unlikely to last:

Benign emerging markets default rates

Emerging markets risk premia still generous

Kolbe and colleagues believe despite the recent rally in spreads, emerging markets risk premia are still generous enough to compensate for a modest rise in default rates. They note annual breakeven default rates at the EM index level remain well above actual EM default rates. However, the analysts take comfort from the fact that current spread-implied default rates are higher than the outcomes observed default rate during various EM country crises:

emerging markets risk premia still compensate

They also point out that Petrobras releasing its FY 14 audited financials has staved off a potential debt acceleration and the release of the result would act as a catalyst for further spread compression, especially at the front end of the curve. The analysts recommend buying Petrobras front end and Romania EUR paper, as it is well positioned to benefit from continued ECB-QE driven demand for CEE paper:

Petrobras front end emerging markets

Turning their focus to currency cross, the Barclays analysts point out that since the bullish USD view has become the consensus opinion, some emerging markets FX trades with low correlations to the USD.

EM FX crosses emerging markets

After studying 42 crosses, Kolbe and colleagues selected those where the r-square of their regression falls within the 10th percentile of sample. This analysis narrowed their selection to five emerging markets FX crosses viz.: INRTWD, INRPHP, IDRPHP, RUBIDR, and CNHMYR. Based on the carry and volatility characteristics of these five currency pairs, the analysts found that INRTWD and INRPHP crosses offer prospect of high carry of close to 8% as well as a better carry-to-vol ratios of over 1.3 times:

Prospects from two currency pairs emerging markets