The worldwide economic slowdown has begun to take a toll in yet another arena of worldwide finance: the default rate of corporate debt in emerging markets. Companies from emerging markets are defaulting on their debt at a rate of 3.8% — the highest level since 2009. Through November 2015, that represents an increase of 40% over 2014. For reference, U.S. companies defaulted at a rate of 2.5% over the same time period.
There has been a complete reversal from just four years ago, when U.S. companies were defaulting on loans at a 2.1% rate while the emerging market default rate was down to 0.7%. The U.S. was just embarking on a relatively slow recovery while emerging market economies were growing at close to 7%, buoyed by tremendous growth in China. Stimulus efforts in the U.S. and other developed nations kept interest rates extremely low, driving more bond investments toward corporate bonds of emerging markets in search of higher returns.
As a result, emerging market debt has increased by a factor of five in just the last ten years. Total debt within emerging markets is now $23.7 trillion. Asian emerging markets hold a disproportionate amount of this debt, as shown by the 25-percentage-point increase of Asian nonfinancial corporate debt compared to GDP.
The slowdown in China's economy has reduced demand for raw materials and finished goods throughout many markets that depended on China for income — not to mention Chinese domestic businesses. Some businesses over-expanded assuming continued high growth and accumulated significant debt during the good times. Lower-than-expected incomes and a strong dollar are squeezing emerging market companies from both directions.
The rise in the dollar has been exceptional, thanks to the relative strength of America's economy compared to most of the rest of the world. From January to March 2015 alone, the dollar saw its fastest rise in value since the 1970s. The last eighteen months have shown an approximate 20% rise in the U.S. Dollar Index (DXY).
Since emerging market companies often hold loans denominated in dollars, the relative weakness of their currencies compared to the dollar makes it even more difficult to repay debt or to refinance existing debt. With the interest rate increase by the Federal Reserve in December, refinancing will become harder still.
This set of circumstances produces a growing amount of emerging market corporate debt and a shrinking number of lenders willing to accommodate that debt. The Institute of International Finance estimates that approximately $600 billion worth of emerging market debt matures over the next year, with $85 billion of that in dollar-denominated loans. Refinancing will be needed for approximately $300 billion in non-financial corporate emerging market debt. Investors may find that debt a hard sell, especially as interest rates begin to rise... or will they?
Even with the rising default in emerging markets, ETFs holding high yield (riskier) debt in emerging markets have generally outperformed their counterparts in U.S. corporate bonds, according to ETFtrends.com. Will that continue with the current default trends? That depends on the holdings of individual ETFs and how they are handled.
As an investor, your job is the same as always — investigate the risk/reward ratio of individual bond holdings or the list of such holdings within a fund. Consider the current trends and re-evaluate the risk based on the most current information before you act. Don't forget to look into the debt of corporate bond issuers, and be very wary of disproportionately high debt with an issuer of emerging market bonds.