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Prepare for a Rough Ride in EM Bonds

Emerging markets have enjoyed capital inflows and access to cheap dollar funding since the global financial crisis. These strengths are about to become weaknesses: a reversal in Federal Reserve policy, falling commodity prices and rising political risks put EM companies and their debt between a rock and a hard place. After the recent strong rally, investors in EM corporate bonds should prepare for a rough ride.

Here’s why. First, private sector debt overhangs continue to grow. While US firms and households restructured their debt during the financial crisis and Europe is doing it now, leverage in emerging markets has just deteriorated. Thanks to capital inflows, private debt has increased by a third in all EM since 2008, doubling in Asia and tripling in emerging Europe, according to the World Bank. Such a rush in lending is often associated with capital misallocation: to households who cannot pay their bills, or projects that will never generate a return for lenders.

Second, there is also a growing dependence on foreign currency funding, making the debt load worse. While EM governments tend to owe a slightly above-average portion of their debt in hard currency, the difference between today and the 1990s is that EM companies have tapped into dollar and euro markets too.

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