Emerging market debt: Reform, resilience, and private credit

Paul Mohr: Hello, and welcome to the Aberdeen Emerging Market Debt Quarterly Perspectives Podcast. I'm Paul Mohr, Senior Director at Aberdeen Investments. Throughout this series, we provide timely insights into emerging market bonds, examining recent developments and the implications for investors. Joining me today is Sid Dahiya, Aberdeen's Global Head of Emerging Market Debt. Sid, thank you for being here and sharing your perspectives with us.

Siddharth Dahiya: Thanks, Paul. Thanks for having me.

Paul: Let's start. In the Middle East, we've seen, well, what we thought we had, a peace deal in place here, a ceasefire, that seems in the recent days here to perhaps be in flux. But I think overall, the view is that there may be a sustained peace deal in place and a gradual normalization of oil flowing through this trade-off Hormuz. How does this change the opportunity set for you guys in emerging markets and where are you seeing the most compelling value today?

Siddharth: Yeah, well, notwithstanding the events of the last couple of days, the easing of tensions in the Middle East and gradual normalization of traffic of oil through Hormuz, this has basically removed a very important tail risk for global markets, right? Earlier in the year, investors were really concerned about a sustained energy shock, higher inflation, more challenging backdrop for risk assets. Those fears have now receded, and we've seen spreads tighten across much of emerging market hard currency debt. The importance of the strait, opening of the strait to global energy markets means that any further normalization is supportive for risk sentiment and particularly beneficial for energy importing emerging economies. Having said that, I don't think investors should look at EMD as a purely broad beta opportunity today. Valuations in some higher quality sovereigns is certainly less compelling than it was six to 12 months ago. But dispersion remains fairly high across countries. So, we continue to find value in areas where A fundamentals are improving faster than the market appreciate. Particularly countries implementing credible reforms, improving fiscal balances, and benefiting from sort of structural flows that come into the country when they do all these good things. In local currency, we still see attractive real yields in a number of countries where inflation has fallen materially, but rate cutting cycles remain incomplete. So, from a very top-down perspective, while valuations in hard currency may look a bit full, active management, in my view, remains very critical because the opportunity set is increasingly driven by country selection rather than just a broad-based asset repricing.

Paul: Yeah, you touched on the dispersion, the high dispersion within emerging markets. I think that really drives home the case for an active management in this space. Kind of diving into some of the specific credit stories here along those same lines, Venezuela was certainly in the headlines for the unfortunate catastrophe there with the earthquake that hit a few weeks ago. Outside of that, though, there is a recovery story there in Venezuela financially. They're going through their restructuring of their debt program. How do you think the decision for them to move forward with that restructuring without the direct involvement of the IMF changes things for you guys?

Siddharth: Yeah, so Venezuela remains a very important topic for the market, and it will be, in my view, one of the most complex sovereign situations or sovereign restructurings in emerging markets. The market has become more optimistic following the political transition that we saw. And there has been a launch of discussions around a comprehensive restructuring process. However, in my view, investors should not underestimate the complexity of what we are dealing with here. It is a very complex, diverse creditor base that includes sovereign bonds, the national oil company, Pedivesa, its liabilities, arbitration claims, bilateral creditors. So, it's a very complex, it is going to be a very complex restructuring.

From a recovery value perspective, I think the key variable isn't only the restructuring terms themselves. It is also the country's ability to restore oil production, reestablish macroeconomic stability, and getting access to international capital markets. And normally, in these kind of restructurings, the IMF plays a very critical role because it provides, usually, it provides a very credible macroeconomic framework and debt sustainability analysis, which is called the DSA. That is important for both creditors and the country's general future financing needs. Most people consider IMF engagement as the key ingredient for a successful restructuring. In the case of Venezuela, that is missing. So, if restructuring discussions were to progress without meaningful IMF involvement, then in my view, there would likely be greater uncertainty around debt sustainability assumptions and potentially greater litigation and holdout risk. In our view, ultimately, a durable recovery requires both debt reduction and credible economic reforms under the purview of the IMF.

Paul: I like how you very politely called that a political transition in Venezuela that happened earlier this year. We did see a more traditional transition of political power, this time over in Hungary earlier in the quarter with an election result with Viktor Orban and his party being ousted in favor of a more pro-European Union stance. How did you guys position ahead of that event, and what have been the opportunities that have come about since?

Siddharth: Yeah, so Hungary is a really good example of how we approach political risk in emerging markets, rather than just simply trying to predict election outcomes with certainty, which many people do, but it's not always easy. Tried to focus on scenario analysis and basically assessing how market pricing compares with potential outcomes. In the case of Hungary, election increased the probability of closer EU integration and the potential release of previously frozen EU funds. Given the scale of these funds and the potential support for growth, investors, understandably, became a lot more constructive on Hungarian assets. Ahead of the election, we felt local markets in Hungary, particularly local markets in Hungary, offered a very attractive risk-reward profile. In particular, local rates and currency both basically offered scope to benefit from potentially improving confidence and perhaps better medium-term growth prospects if relations with Brussels improved. So, our positioning reflected that view, that Hungary's medium-term economic outlook could improve materially if policy predictability increased and EU funding began flowing again. And that really worked for us. Hungary was one of the best performance for us on our local currency side.

Siddharth: Oh, great.

Paul: And yeah, it'll be interesting to see how that situation really plays out in Hungary and if that's kind of the canary in the coal mine for other kind of right-wing parties across the globe, or if this is just really a one-off. Let's change topics a little bit here, Sid. And this next question is going to be a callback to those dedicated listeners who listen each and every quarter. A few episodes ago, you and I were talking, and you touched on the idea of private credit within emerging markets. So for those of us less familiar, I guess, can you first really just explain the private credit universe in EM and what that actually is and how does it differ from the traditional kind of public markets with an emerging market debt?

Siddharth: Yeah, I mean, private credit in EM is a developing field, is an excellent sort of a nascent field where you don't often see direct lending, which is the dorm in developed markets. So, for example, in the US, let's say, what is considered private credit is often purely direct lending and also often sponsor-led financing. So, you'd have private equity sponsors buying a company, and they would get financing done for a leveraged buyout, for example. In the case of EM, both those elements are largely missing.

Paul: The private market in EM at the moment is very much a syndicated club deal kind of loan market. So very basic in nature. But it, you know, from our perspective. What is particularly interesting is that many of the opportunities we see are basically linked to long-term structural themes, right?

Siddharth: The infrastructure, energy transition, maybe digitalization, asset-backed lending, export-oriented business. So, it's very different from what is, you know, the modern definition of private credit in developed markets. In recent weeks, in recent months, there has been a lot of heat in developed markets around private credit, and much of that is focused around a vast amount of direct lending that has been done to software companies, which potentially their business could be disrupted by AI. In the case of EM, that isn't just isn't the case, that there is no lending to software or technology companies. It's a very old economy industries that borrow money using syndicated loans, largely syndicated loans.

Paul: So, with that then, I guess, where are you guys seeing opportunities within the private credit space today? What are the advantages that it offers investors versus a traditional kind of EM loan?

Siddharth: Yeah, so in EM, public markets have obviously attracted a lot of investor attention over the last few years, and particularly last year, EM is very much back in vogue.

Paul: And in many segments, many parts of EM, spreads have retraced meaningfully, right?

Siddharth: Private credit in EM offers a slightly different proposition. Companies and borrowers, as I've explained just now, across emerging markets in certain parts of emerging market continue to face a financing gap, particularly as traditional bank lending remains constrained in some jurisdiction across EM. In our view, for investors with the right sourcing capabilities and local expertise, local expertise in the sense of understanding local laws, jurisdiction, constraints, et cetera, this can, in our view, can create opportunities to earn very attractive illiquidity premiums while maintaining strong structural protections and downside safeguards, right, as we do on the public side as well. In our view, the opportunity set is not about taking more risk. It is about being paid appropriately for the complexity, illiquidity, and the specialized underwriting that we do. So, I think in our view, you know, what we've seen this segment grow. We have been more active in this segment in the last six to nine months. And there's a little other part of the market in the form of private placements, which has also become much more active in EM. So recently, we have seen companies that would otherwise use the public markets come as private placements in our market. And that has been a great avenue for seasoned investors in EM to tap into perhaps the illiquidity premium or the new issue premium or price discovery to get very attractive returns for our investors. So, it is a growing market, something that we are paying close attention to.

Paul: Yeah, I mean, it's really exciting stuff. And I think we could probably do a whole episode just focused around some of the private credit opportunities. But unfortunately, we're running up against time here for this episode. So, with all that said, I just want to say thank you for your time and joining us today.

Siddharth: Great. Thanks for having me, Paul.

Paul: And thank you to everyone who took the time to listen in to today's episode. If you enjoyed the episode, then please download our other podcasts from our website or wherever you normally find your podcasts. Thank you.