How will emerging market corporate debt fare through the first real challenge since it became a genuinely mainstream asset class? Federico Carballo and Florence Duculot offer their prognosis
Emerging markets corporate has been one of fastest growing asset classes – with a growth of nearly 140% in the past three years, versus 52% for sovereign EM debt and 42% for US high yield – at a time when a good part of the more mature and traditional fixed-income or credit markets have been stagnant or shrinking in size. The pace of issue of corporates is now twice that of sovereigns and, for the first time ever, the $466bn (€547bn) market capitalisation of the EM corporate debt universe (as measured by the JP Morgan CEMBI Broad index) has surpassed the $457bn of the EM sovereign debt (as represented by EMBI Global).
EM total outstanding eurobond corporate debt has now also crossed the $1trn mark, surpassing US high yield, and standing at four times the size of European high yield. Taking into account the local currency debt, the total outstanding EM corporate debt is close to $2.9trn, having doubled since 2008.
The corporate hard currency eurobond segment remains, by far, the main investible vehicle for global investors, and is poised to gradually take over the EMBI index as a reference vehicle for hard-currency-debt investing.
In addition, the corporate debt market, which was initially more a Latin America phenomenon, is now well diversified and of relatively high quality; the proportion of high-yield to investment grade is 30% to 70%.
Over the past decade, the asset class has delivered very attractive risk-adjusted returns while being a good source of diversification for global investors: since 2003, the CEMBI broad index has delivered an annualised rate of 8%, while the high-yield segment has returned 12% versus 10% for US high yield. Over the past five years, EM corporate has also demonstrated resilience as an asset class in spite of challenging external conditions, a peak in defaults and credit events and change in liquidity.
The asset class is gradually benefiting from a slow but changing structure of investors, with dedicated investors having doubled to represent $60bn, which contributes to more price stability.
As an asset class that has strongly benefited from the search for yield, in the sell-off driven by quantitative easing tapering, EM corporates have suffered sharply, starting with the investment-grade names sensitive to the moves in US Treasuries, but including the high-yield segment exposed to sharp liquidity gaps.
History shows that rising rates, especially in a volatile pattern, usually lead to wider spreads, due to both technical overshooting and fundamental factors. Although the macro background is in no way similar to the tightening episode of 1994, as most emerging countries exhibit much more solid fundamentals (low public debt ratios, manageable current account and fiscal deficits, large foreign exchange reserves, flexible exchange rates), the perception of a weakening macro picture at the margins since 2012, with broad downward revisions in GDP growth, deteriorating current account positions, worsening labour costs and negative commodity prices trends, have added fuel to the fire of the May-June correction.
As US rates find a new footing, the main threat of additional underperformance comes from a potential new round of outflows out of EM fixed-income markets. Of note, one of the main weak points of the asset class is its relatively low liquidity as the substantial growth of the market has been barely accompanied by a rise in market participants or trading volume, due to the much lower risk participation of investment banks.
While EM corporate balance sheets are of relatively high quality when compared with their own history and to US high yield, and refinancing needs are manageable at least until they really start to pick up in 2016, there are nonetheless channels of market volatility transmission to watch, especially the impact of weaker EM currencies.
The sharp depreciation of certain EM currencies – in the order of 10% for the commodities-linked currencies – will affect balance sheets in the months to come, weakening those with large US dollar debt stock, low cash and hard currency revenues, and probably leading to some covenant breaches in certain high-yield issuers with already high leverage ratios.
Default rates have already increased this year and are expected to flirt with 4%. Pressures are mainly coming from Latin America but defaults have actually been concentrated in one specific sector, Mexican homebuilders, which are trapped with a bad business model and would have defaulted anyway.
The adjustment towards tighter liquidity will gradually feed through more economic variables and lead to substantial performance differentiation at the sovereign, sector and corporate level. And in this cycle, it is not only the US liquidity adjustment that one has to watch, but also the slowdown and change of growth structure in China, which will determine the fate of commodities, the fate of many emerging countries and of corporate cash flows.
These two factors are closely related: either the US recovery is strong enough and stirs up China and with it other EMs; or it is held back by the weak state of its trading partners and rate normalisation is pushed further into the future.
In an undoubtedly more challenging cyclical context, EMs nonetheless benefit from supportive structural factors to muddle through this phase of sub-par growth and liquidity tightening. Except for a few countries, public sectors are not an issue and have some policy flexibility to support private sector growth in a tightening liquidity context. Domestic demand and infrastructure investments will remain the two pillars of growth. In addition, compared with two decades ago, corporates are not as dependent on foreign capital, as local markets now provide a valuable alternative source of funding.
The asset class will survive this new stress test, offering a valuable excess yield – nearly 800bps spread in high yield, superior medium-term returns based on growth differential and increased diversification benefits, given its now wide-ranging universe. But in a more volatile period for EM corporates, performance differentiation will be striking between credits. An active fundamental strategy, with nimble asset size exposure, will benefit from the numerous pockets of value left by the usual market overshooting on a bumpy road to interest rate normalisation.
Federico Carballo is portfolio manager for the Latin America High Yield fund, and Florence Duculot is a portfolio manager, at Buenos Aires-based Copernico Capital Partners