External Debt Valuation
Valuations in the external sovereign debt market became slightly less attractive in the third quarter. As seen in Exhibit 1, the current multiple of the benchmark’s credit spread to the spread that would be required to compensate for credit losses fell over the course of the quarter. That multiple stood at 3.2x on September 30, 2019, down from 3.4x on June 28. Based solely on the historical experience, this multiple of 3.2x is still within the range of values that we would consider attractive. As described in more detail in the appendix, a ratio above 3.0 has, over the past 25 years, resulted in positive credit spread returns over the subsequent 24-month period, 90% of the time.
The main reason for the decrease in the multiple was a decline in the EMBIG spread, which fell by 28 bps over the quarter, due in part to index compositional changes described below. Comparatively, the “fair value” spread of the EMBIG that would be required to compensate for expected credit losses fell only 3 bps, from 110 bps at the end of June to 107 bps at the end of September. Regular readers will recall that this fair value spread is a function of the weighted-average credit rating of the benchmark, along with data and assumptions on rating transition probabilities and recovery values given default. As mentioned in last quarter’s publication, the phasing in of several GCC countries into the EMBIG benchmark have continued to apply downward pressure on the fair value spread. These countries generally have high credit ratings, and their phased inclusion is increasing the overall credit quality of the underlying benchmark, therefore lowering the theoretical credit spread required to compensate for credit losses. Another factor in favor of a lowering of the fair value spread was Venezuela’s declining weight in the benchmark, which fell from 1.0% to just 0.2% over the course of the quarter. Partially mitigating these effects were rating changes for the countries in the index, which were slightly negatively skewed in the third quarter. Most notably, Argentina was downgraded multiple notches as currency and volatility soared and the government opened conversations on a restructuring of its outstanding obligations. Elsewhere, we saw downgrades for Zambia and Trinidad, and upgrades in Jamaica and Ukraine.
The preceding was a discussion of the level of spreads, or credit cushion. From a total return standpoint, the level and changes of the underlying risk-free rate also matters. In the third quarter, trends in U.S. Treasury yields were once again a major contributor to returns, with the 10-year yield falling another 34 bps. We measure the “cushion” in Treasuries by the slope of the forward curve of the 10-year swap rate, depicted by the light-font lines in Exhibit 2. The interest rate “cushion” (which we proxy as the slope of the forward curve) continues to be low by historical standards, meaning a sharp rise in the 10-year Treasury yield would be a surprise to the market. The slope of the 10-year forward curve ended the quarter at just 8 bps, even lower than the 21 bps of the prior quarter.
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