A structural advantage is baked into emerging market corporate debt, but exploiting it is dangerous without intense credit work. Caroline Saunders finds a market coming out of childhood but not yet an adult
The combined GDPs of emerging economies overtook those of developed economies during 2013. It was an important year. But it was in 2012 that the hard currency emerging market (EM) corporate debt market exceeded the US high yield bond market. And the market capitalisation of emerging market (EM) corporate bonds surpassed that of EM sovereign bonds, at index level, several years ago: in the past decade there has been an 11% increase in the EM sovereign dollar bonds compared with a 33.5% increase in the EM corporate dollar bonds.
From failed Latin American bank loans in the 1980s, to Brady bonds, via yankees and eurobonds, EM corporate bonds are today an asset class of growing importance.
“We’ve been investing in this sector since the late 1990s,” says Paul DeNoon, director of EM debt at AllianceBernstein, “and it’s noticeable how we much have increased our coverage as growth has accelerated over the last couple of years in particular.”
Despite the traumas suffered by EM sovereigns last year, corporates held out well; the JP Morgan CEMBI Broad Diversified index fell only 0.6% in US dollar terms
“EM corporates are not immune to downturns in the sovereign domain,” says Investec’s emerging market corporate bond portfolio manager, Victoria Harling. “They can’t be – they’re not only beholden to corporate governance, but also sensitive to underlying economic growth and currency dynamics. However, hard currency EM corporates did not do too badly last year.”
Local currency EM corporate bond markets are also growing, and outsize the hard currency market, but much of this issuance tends to be less liquid and less accessible to foreign investors. Pictet’s Alain-Nsiona Defise says it will develop much more over the coming years. “It allows us to access a much more granular part of the market. In Russia, for example, the ruble-denominated bond issuers include sectors that are not present in the hard currency universe.”
Managers are quick to challenge the charge that EM corporate hard currency issuance is creating a currency mismatch, balance-of-payments ‘time bomb’.
“We’re not dismissing risks of companies issuing their debt in external currencies,” says Stone Harbor Investment Partners’ Bill Perry. “We always investigate currency-matching very carefully, we need to be constantly sure a company can sustain FX volatility.”
BlueBay Asset Management points out that, for many issuers, their industries are dollarised, anyway.
“For financials and oil issuers, which constitute more than one-third of the market, much of their revenue streams would be in US dollars, anyway, so mismatching is not the issue,” explains portfolio manager Anthony Kettle. “However, when we’re researching any company, we always ask careful questions about hedging policies. It became clear in 2008-09 that some corporates had got into trouble because they were speculating on currencies through derivatives, rather than hedging their liabilities, and this caused problems when they were brought on to balance sheets which were in some cases highly leveraged.”
The hard currency corporate sector is diverse, with over 500 companies representing more than 45 countries in the CEMBI BD, and with issuance over a wide range of maturities too.
“There are a surprising number of 30-year bonds out there, and the vast majority are investment grade,” says Kettle. “Overall, the maturity profile is pretty well staggered. Latin American and Asian corporates issue across the curve, while emerging Europe tends to be five and 10-year, and for the Middle East it is five-year issuance in the main, given the preferences of the local investor base.”
The two biggest sectors within the CEMBI BD are financials, which account for about a third, quite similar to its DM corporate equivalent, and oil and gas, which represents around one-fifth.
“The supply side is healthy,” says Rob Drijkoningen of Neuberger Berman. “With these countries moving up the development ladder, their domestic corporates often have to turn to other means of funding as they can no longer rely on sufficient capital coming from their old sources, like their banks or other family businesses. And there’s not necessarily a link between the issuance of hard currency corporate debt in a country and whether its domestic market is developed.”
One generalisation that can make for EM corporates is that rating agencies tend to be more strict about leverage levels; a higher credit quality is required compared with similarly-rated DM equivalents. “Some of this makes good sense, if one considers transparency issues, or bankruptcy codes, for example,” says Perry. “Sometimes, however, the ratings can be a little anomalous.”
BlueBay’s Brent David agrees that EM corporate fundamentals compare favourably to those of US credit. “More importantly, leverage has actually been relatively stable over the past year, which is not what the headlines might have you believe,” he says. “Overall in the index, net leverage has indeed moved higher, but it’s mainly driven by some specific Latin American quasi-sovereign issuers. So often there is a lot of noise to strip out.”
Despite the gap in perceptions, Pictet believes that the line between DM and EM is blurring, says Defise, in terms of improving transparency, growing liquidity and tightening bid-offer spreads in bonds from the likes of Brazil’s Petrobas, Mexico’s America Movil or CNOOC from China, and a large number of banks implementing Basel III protocols. “It’s getting there,” he says.
But at the same time it helps that a significant proportion of the corporate debt market is domestically owned. Investec’s Harling explains: “We really like the technicals of this asset class. We know that approximately $70bn is in dedicated portfolios. And although there is a sizable crossover bias to the Latin American debt ownership, in Asia the ownership is predominantly local. In Russia, local buyers have been replacing the international sellers.”
Diversity of investors is a good thing, agrees Perry. “In addition to the dedicated [international] funds there are very significant local pension fund and insurance company investors,” he observes. “Now more credit investors are allocating their assets globally, including into EM corporates, across selected industries.”
As all of these portfolio managers would attest, this is an asset class that takes a lot of irreplaceable work to understand its credits. But underneath that, it is becoming more robust and predictable.
“I like to compare our market to an adolescent: it’s now very large but it is not yet mature,” says Defise. “Sometimes you expect an adolescent to misbehave – however, the market really has been quite resilient, especially over these last difficult 18 months or so. No, this market is not immune to higher US Treasury rates, but we are of the view that if it’s a gradual increase, then we’ll again see the same sort of resilience as we saw last year.”
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