Boston - Emerging markets (EM) debt has faced a challenging year in 2022, along with almost all other fixed income sectors. EM countries with significant problems typically garner the most headlines, especially if their debt falls into "distressed" status — usually defined as trading at a spread of 1,000 basis points or more.
Headwinds for EM debt issuers this year combined in a "perfect storm," including:
- Higher borrowing costs/interest rates to pay back creditors in this elevated rate environment
- Stressed fiscal policies
- The general risk-off environment
This has resulted in an unusually high number of distressed debt EM countries, rising from under five a decade ago to about 20 currently.
The MSIM Emerging Markets Debt team builds portfolios by focusing on country-level macroeconomic and political research and stand-alone analysis of specific risk factors such as currency, credit spreads and interest rates. Over our two decades of investing in EM debt, this process has guided us in navigating distressed debt environments.
Our close analysis reveals there is a repeatable distressed debt investment process — part art and part science — that can be applied over time. But this requires a high level of active engagement by managers with expertise in EM countries, along with a good deal of persistence and patience. As discussed below, active engagement has led to greater recoveries — an outcome that benefits both EM issuers and investors.
Patterns in Distressed Debt
We reviewed 12 restructurings between 2008 and 2018 and found that bond prices have tended to fall strongly in the three weeks leading up to a restructuring announcement, and then usually bottom out over the subsequent two months. Over the next three months, the defaulted bond prices increased by an average of 20%.
We believe there are several reasons for the rebound. By the time of the restructuring, the only remaining investors are those prepared to see the issuer through its problems. Also, some countries are spurred to enact long-overdue reforms, perhaps with IMF assistance.
The chart below shows that active engagement by EM investment managers has been crucial for successful restructurings. Creditor committees that have engaged with debtors had a median recovery of 60 cents on the dollar, over less than one year, versus 30 cents over more than two years, with no engagement, based on a review of 24 restructurings over the past several years.
Active Engagement Has Recovered More Value, More Quickly
Source data set: 24 bond restructurings from Park & Samples (2021), Asonuma & Trebesch (2016), Cruces & Trebesch (2013) and Eaton Vance's data set, December 2022.
These results underscore the extra mile active managers must go for successful restructurings. In our experience, the manager needs to travel to the country and meet with key policymakers like the minister of finance, central bank governor and the IMF. It isn't enough just to review restructuring proposals — the manager needs to have a seat at the table to help devise it.
Bottom line: Our research shows that when managers engage intensively in restructurings, both issuers and investors can benefit.