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The Biggest Emerging Market Debt Problem Is in America

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The Biggest Emerging Market Debt Problem Is in America

A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of financial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole.

CAMBRIDGE – A recurrent topic in the financial press for much of 2018 has been the rising risks in the emerging market (EM) asset class. Emerging economies are, of course, a very diverse group. But the yields on their sovereign bonds have climbed markedly, as capital inflows to these markets have dwindled amid a general perception of deteriorating conditions.

Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts.

What’s driving this divergence? Are financial markets overestimating the risks in EM fixed income (EM yields are “too high”)? Or are they underestimating risks in lower-grade US corporates (USEM yields are too low)?

Taking together the current trends and cycles in global factors (US interest rates, the US dollar’s strength, and world commodity prices) plus a variety of adverse country-specific economic and political developments that have recently plagued some of the larger EMs, I am inclined to the second interpretation.

In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world.

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