EM corporate debt: an emerging asset class
Charlotte Moore examines the attractions of emerging market corporate debt, which has evolved rapidly in terms of issuance in recent years
At a glance
• Investors remain skittish about emerging market corporate debt but last year’s torrid conditions acted as a stress test.
• Despite capital outflows, financing constraints and lower economic growth, emerging market corporates outperformed the US high-yield sector last year.
• The credit quality of the companies coming to market is high and debt levels are lower than in the developed world.
• Some institutional investors are considering increasing allocations to emerging market corporate debt.
Institutional investors have been skittish about allocating to emerging market corporate debt. There are concerns about the impact of lower economic growth on the asset class. In addition, many believe it is still bedevilled by bad governance and liquidity constraints.
Investor concern over the outlook for the emerging markets is understandable. The Chinese economy, which has been the powerhouse of global growth for many decades, is expanding at a lower rate. And the country’s diminished appetite for commodities has huge ramifications for other emerging economies.
But even though growth prospects are dicey, last year’s torrid market conditions acted as a stress test for emerging market corporate debt. Risk aversion led to capital outflows from emerging markets last year. Rob Drijkoningen, co-head of emerging market debt at Neuberger Berman, says: “Emerging market corporates had to adapt to more constrained financing alongside lower economic growth. Despite these difficulties, dollar-denominated debt performed relatively well last year.”
According to Samy Muaddi, portfolio manager of the T Rowe Price Emerging Markets Corporate Bond fund, total returns on emerging market corporate credit were 1% last year. That might not sound like particularly high returns but the performance was still better than that of US high yield.
The sector’s resilience to last year’s difficult market conditions is also reflected in the low number of credit defaults. Last year’s default rate for the broad diversified corporate emerging market bond index was only 2.4%.
The relative strength of emerging corporate debt last year illustrates the problem associated with viewing emerging markets as a homogeneous group and assuming lower economic growth will be negative for both equities and fixed income in every nation and for every company.
The reality is much more complex. Steve Cook, co-head of emerging markets fixed income at the New York-based manager Pinebridge, says: “To evaluate the investment opportunities correctly, investors need to break down the emerging markets into the individual components.”
Put simply, lower economic growth has different implications for shares and bonds. Cook points out that equities are much more sensitive to lower economic growth than fixed income; lower growth usually equates to lower interest rates which tends to be positive for fixed income.
Not only are investors incorrect in their generalised assumptions about the impact of lower economic growth on emerging market corporate debt but their view of this asset class as one suffering from extreme liquidity constraints and bad governance is no longer valid.
Issuance has increased rapidly in recent years: dollar-denominated corporate debt issuance is now around $1.7trn, compared with $700bn in 2011, according to Cook. Most of the dollar-denominated debt is primarily investment grade – high-yield makes up only 35%.
Dollar-denominated debt is the asset class of choice for institutional investors as it is much less volatile than local currency debt. But there are still concerns about the ‘original sin’ of borrowing dollars while collecting revenues in a weaker, local currency.
“Some investors worry that if the value of the local currency were to fall, it would make it more difficult for companies to repay their dollar-denominated debt,” says Maxim Vydrine, head of the Amundi Bond Global Emerging Corporate fund.
However, the robust performance of the dollar-denominated broad diversified JP Morgan corporate emerging market bond index last year illustrates that worries about ‘original sin’ can be overblown (see figure).
The strong index returns were partially due to mining and oil companies making up 26% of the index. Vydrine says: “Many of these companies receive dollar-denominated revenues while their costs are paid in local currency.” This creates a natural hedge for these companies. In addition, while commodity prices have fallen rapidly, this was matched by a decline in the value of the local currency.
Not only has the dollar-denominated emerging market debt performed better than some might have expected but the US-dollar asset class has continued to evolve rapidly. For example, the number of corporate issuers has increased to 650 compared with 321 in 2011. The average market capitalisation of the index has now increased to $1.7bn and 53 countries are represented in this index.
This increase in market capitalisation and stock diversification makes it much easier for managers to express a particular investment conviction. Cook says: “Managers can now avoid particular countries or sectors if they have concerns about their investment prospects.”
For example, it allows investors to pick those companies that would not suffer if the value of the dollar strengthens further against the local currency because they receive a good proportion of their revenues in dollars.
Nor is emerging market corporate debt as risky as some investors might assume. Cook says: “The investment grade component of our emerging market corporate portfolio is less volatile than US BBB-rated debt.”
That is because the underlying credit quality of the emerging market companies issuing the dollar-denominated debt is high. “Only those companies with the necessary credit quality and auditing standards can engage in the international bond market,” says Muaddi.
In addition, many emerging market corporates have much less debt on their balance sheets than their counterparts in the developed world. “Despite the difficulties faced by the emerging markets over the past two to three years, the level of leverage remains at a manageable level for most of emerging eurobond issuers,” says Vydrine.
This lower amount of leverage also helps to explain how emerging market corporate debt managed to weather last year’s storm with defaults peaking. Muaddi says: “We expect the peak default rate for the high-yield portion of the emerging corporate debt market to be 6.5%.” The overall default rate for the whole market is only 3.5%, as investment grade makes up the bulk of this market.
Corporate governance has also improved in recent years. But investors should still demand a premium for investing in emerging markets. Cook says: “While bankruptcy laws have improved, it still is not as reliable as similar rules in the developed markets.”
An active credit portfolio manager needs to be able to accurately assess the creditworthiness of individual companies to be able to pick the winners and avoid the losers. This requires the analysts working on the fund to be able to access transparent financial information.
Cook says: “When I first started in the market several decades ago, the information in the annual report and accounts was patchy and usually not translated into English.” Now the executive boards of the companies travel frequently to talk to international investors. “Companies realise the greater the transparency, the lower the cost of funding their company,” he adds.
While the advances in emerging corporate debt markets have made this asset class more appealing and the fundamentals remain strong, valuation is an important consideration for any investor looking to increase or initiate an allocation to this asset class.
Spreads have narrowed since the recovery in the price of oil and commodities since the end of January. Steve Drew, head of emerging market credit at Henderson, says: “While much of the easy money has been made, there is still a good chance for emerging market debt to have higher returns than other credit asset classes over the medium term.”
But making the best possible returns out of emerging market corporate debt will only be possible through careful stock selection. Drew says: “We are in the late stages of a credit cycle, so there is a good probability that defaults will be higher than the market currently anticipates.” A good manager should be able to avoid the banana skins and pick those issues which will generate better returns than the market, he adds.
There are indications the improvements in liquidity and corporate governance along with the resilience of emerging corporate debt has pricked the interest of investors. Muaddi says: “We have seen an increase in the number of requests for proposals from investors.”