VanEck: Do Emerging Market Bond Credit Ratings Affect Returns?

November 28, 2016

[The following "ETF Industry Perspective" is sponsored by VanEck.]

Credit rating upgrades and downgrades occur frequently, but two rating actions in September stood out in particular: Turkey's downgrade to noninvestment-grade status, and Hungary's upgrade to investment-grade status. Following the attempted coup in Turkey this past summer, a credit rating downgrade by Moody's Investors Service in September pushed the country into the noninvestment-grade category based on the credit rating methodology of the J.P. Morgan EMBI suite of indices, which track U.S. dollar-denominated emerging market sovereign bonds. By contrast, Hungary benefited from a rating upgrade by Standard & Poor's, which cited the country's improving fiscal, external and growth expectations. This upgrade allowed Hungary to once again be included in investment-grade-only indices.

Forced Selling And Buying May Impact Bond Values
Changes in investment-grade status can significantly impact a bond's market price. There are many investors who track quality-based indices only, or can only invest in investment-grade bonds. When a bond is either downgraded from or upgraded to investment grade, these investors may be forced to buy or sell bonds based on shifting ratings. The market, however, is not driven entirely by credit ratings, and market prices often anticipate credit rating changes.

In the chart below, Hungary and Turkey credit spreads (as measured by Z-spread1 levels of country subindices of the J.P. Morgan EMBI Global Index2) are shown along with credit rating changes to or from investment-grade status by individual rating agencies.

Spreads Diverge Ahead of Ratings Changes
Although Hungary and Turkey credit spreads were at similar levels and generally moved together through 2014, these spreads began to diverge in early 2015. As Turkey's credit spreads widened, Hungary's credit spreads generally tightened. These spread changes occurred well before the countries' changes in investment-grade status, indicating that the market's assessment of credit risk may have anticipated these rating actions.

For an investor in U.S.-dollar-denominated Hungarian sovereign bonds, this translated into an 8% cumulative return attributable to credit spreads from 12/31/2014 to 9/30/2016. During the same period, Turkish bond investors lost 1% based on credit spreads. Although isolating the impact that credit spreads have on returns helps to understand the market's view of a country's credit risk, total returns are also driven by other factors, such as interest rates. Overall for the period, Hungarian bonds posted total returns of 14% and Turkish bonds returned 6% (as measured by country subindices of the J.P. Morgan EMBI Global Index).


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