Emerging market corporate bonds staged an impressive performance in 2009. T. Rowe Price has just produced a paper outlining the opportunity for institutions to diversify their bond alpha.
As an asset class, emerging market corporate bonds are taking a more prominent role in fixed income portfolios, particularly as emerging market economies have reduced sovereign debt in the last few years. Nonetheless, the emerging corporate bond market remains little understood by many investors, clouded by the perceptions of illiquidity and high risk.
What distinguishes corporate bonds in emerging markets from other fixed income assets is the ability for investors to take exposure from both credit and sovereign perspectives. Performance has kept pace with emerging market sovereign and US high yield bonds over five-year and one-year periods. Furthermore, its high correlation to emerging market debt, US high yield and US corporate investment-grade asset classes should allow it to be viewed as an extension of the fixed income investment universe. Nevertheless, while more than 70% of the market is rated investment grade, for many investors the emerging corporate bond market continues to be clouded by the perceptions of illiquidity and high risk.
The market’s rapid growth in the last three years is helping to address liquidity concerns. The amount of outstanding debt in the secondary market was $710 billion as of 31 Dec 2008. Corporate bond issuance (external debt) amounted to $1.3 trillion between 2005 and 2008 (see Chart 3). New issuance has been very strong in the year to date ($78 billion to 21 Sept 2009), and most deals have been oversubscribed. J.P. Morgan estimates that total issuance will be $103 billion for 2009.
Average new issue size has been between $400 and $700 million, with the largest deals (greater than $1 billion) mostly from quasi-sovereign issuers. Corporate growth has been spurred by the recent financial crisis, as banks withdrew lending and tighter credit conditions encouraged corporations to access the capital markets for their financing needs. Nonetheless, longer-term advances were under way pre-crisis, helping to underpin this expansion. The implementation of capital market and pension reforms in a number of emerging economies has been pivotal to building market infrastructure and, in turn, attracting a stable “buy and hold” investor base. These reforms have also stimulated supply in locally denominated corporate bond markets, doubling that market’s size from $344 billion to $710 billion between 2005 and 2008.
At the same time, demand for external corporate emerging market debt has been buoyant, particularly in a low interest rate environment. Near-term trends appear encouraging as cash-rich investors may steadily increase risk appetite on strengthening commodity prices and continuing loose monetary policy of G3 economies into 2010. J.P. Morgan estimates that in the fourth quarter of this year, the reinvestment rate from cash flows, maturities and coupons will be 95% (an estimated $25.5 billion available for reinvestment of an estimated $24.3 billion in new supply).
The launch of J.P. Morgan’s Corporate Emerging Markets Corporate Bond Index (CEMBI) two years ago illustrates the rising importance of the asset class to external investors. Compressed corporate spreads in developed markets, especially in the US, are encouraging investors to look for additional yield globally (the CEMBI currently yields 6.95%). As of 31 October 2009, the average duration in the index was 5.59 years, the average maturity was 8.47 years and the average corporate issue has around $890 million (face amount) in outstanding debt (the actual value is probably slightly higher, given that the index only permits the two largest issues from a single corporation).
Trends toward a broader and deeper market are improving liquidity, but what risk factors are associated with emerging market corporate bonds? Their distinct feature is the composition of the yield spread risk premium: It comprises both corporate default risk and sovereign risk. In contrast to developed corporate bond markets, credit ratings agencies impose a “sovereign ceiling,” implying that corporate bonds in emerging markets cannot be rated higher than their sovereign country.
There are a few exceptions for certain local debt instruments, but the guiding principle remains consistent: The political and economic context always matters when rating and assessing corporate emerging market bonds. Empirical studies support the view that country risk has a significant influence on company risk in emerging markets. Moody’s found that nearly three-quarters of emerging market corporate or sub-sovereign defaults occurred during a sovereign crisis (for example, Russia in 1998 and Argentina in 2001—2002).8 Investors need the assurance that a sovereign will not freeze assets, impose capital controls or unduly affect the operations of the corporation. The Brazilian government sharply reminded investors of such risks when it imposed a 2% financial transaction tax (IOF) tax on portfolio equity inflows in October of this year.
Corporate bond analysis in emerging markets needs to be multi-disciplinary, combining the analysis of traditional credit metrics with the macro economy. From a micro perspective, an investor will analyse the level of indebtedness and its appropriateness given the company’s or sector’s operating risks, bond covenants (such as limits on leverage, asset pledges, or a change of control), and capital expenditure plan and look at how often the company is likely to require external funding.
At the macroeconomic level, interestingly the Moody’s study found that higher-rated corporate bonds in emerging market economies were no more likely to default than their equivalent rated bonds in advanced economies. Investors should feel reassured, therefore, that the supply bias in 2009 (75%) has been toward higher-rated investment-grade corporate bonds, mostly in the quasi-sovereign sector.
Capturing global emerging growth Moreover, emerging market credits provide investors with the opportunity to capture the broader emerging growth story. With China being the main driver of emerging market growth, its demand for commodities will undoubtedly increase. Energy companies, for example, are negotiating good financial terms, accessing new markets, diversifying their revenue stream and, importantly, enhancing their liquidity profiles to the benefit of existing bondholders. Two Brazil-based energy companies have recently secured a $10 billion loan from China Development Bank Corporation for offshore oil and gas exploration.12
Global rebalancing efforts are also fostering domestic-demand-led recoveries in Brazil, India and China, which may provide potential investment opportunities. For the BRIC economies, domestic demand is forecast to rise by 8.3% (in aggregate) year-on-year in 2009, while contracting by 3.4% year-on-year in the US.12 Arguably, as economies recover, corporate exposure will be geared more to growth than to sovereign exposure.
Indeed, there are signs that the property sector is benefiting from strengthening private consumption. China’s residential property market has been boosted by fiscal stimulus measures in the first half of 2009, following a fall in prices in the second half of 2008.
One of the largest property holding companies in China recently issued a $300 million seven-year bond (10.5% yield to maturity) to fund land acquisition for residential development.
An expansive universe
As the recent global economic crisis recedes, growth should accelerate in emerging economies relative to the developed world. We believe corporate debt provides the best fixed income opportunity to reflect a positive investment view on domestic demand growth in emerging markets. Furthermore, it broadens investment choices for investors and provides the opportunity to gain country exposure and take advantage of improving credit stories. The additional sovereign risk allows investors to capture a higher yield, while an implied sovereign guarantee may lower the probability of corporate default. Sovereign risk is inextricably linked to corporate risk, and investors need to potentially make a thorough country assessment, in addition to traditional credit analysis, before deciding upon an investment. It requires a unique skill set. However, when applied well, it can provide investors with an alternative source of alpha.