COVID-19 crisis: an emerging-market corporate bond perspective
In the latest of our series of short interviews, Claudia von Waldkirch, Senior Portfolio Manager, discusses emerging-market (EM) corporate bonds and explains why she sees particularly favorable opportunities in Latin American (LatAm) issuers.
How is this crisis different from its predecessors?
A number of crises have afflicted the EM complex in recent decades. The impact of most of these was typically confined to individual countries or sectors. This time, however, very few segments within the universe have been able to evade the talons of the COVID-19 pandemic, not least because the sophistication and capacity of local healthcare facilities lag behind the levels seen in the developed world. Consequently, this crisis has more in common with the all-encompassing 2008 GFC than it does, for example, with 1998’s Asian Crisis or the Tequila Crisis that afflicted Mexico in 1994/95.
This crisis has more in common with the all-encompassing 2008 GFC than it does, for example, with 1998’s Asian Crisis or the Tequila Crisis that afflicted Mexico in 1994/95.
However, the major differences lie in the speed of the initial market downturn, the pace and extent of the fiscal response on the part of governments and the coordinated way in which central banks have injected liquidity through aggressive and swift monetary policy measures. It is also worth bearing in mind that many LatAm countries have embarked on far-reaching reform programs in recent years. Continuing on a reform path is necessary for the majority of LatAm countries and their long-term sustainability, especially considering the current coronavirus crisis as governments spend on the fiscal side to mitigate the economic downturn.
What has been the impact on credit spreads?
In LatAm, for example, in the post-GFC era, the historical average credit spread level is 408 basis points (bps), but this quickly ballooned to approximately 869 bps at its peak as investors scrambled to take risk off the table. Volatility invariably creates attractive entry points, and although spreads have subsequently narrowed to around 618 bps and the major inflection appears to be in the past, plenty of compelling opportunities remain for strategic investors with a medium-term investment horizon.
Plenty of compelling opportunities remain for strategic investors with a medium-term investment horizon.
In what ways can active management help to harness these opportunities?
It is important to understand the impact of sovereign ratings on corporate securities. In recent years, the number of EM sovereigns attracting investment-grade (IG) ratings has increased substantially, but in overall terms, the spectrum remains very wide, especially in LatAm, where Chile is rated A+ while Argentina languishes on the lowest high-yield rating rung. Generally speaking, credit-rating changes at a country level are normally applied in equal measure to numerous companies, especially state-affiliated, system-relevant banks or strategically relevant companies. The methodologies employed by rating agencies typically do not allow a company to have a higher credit rating than the country in which it is headquartered. However, rating agencies exercise a degree of latitude with regard to robust companies with worldwide operations or a bias toward exports, classifying their securities notches above their respective countries’ sovereign credit ratings. This enables active investors to identify and capture excess risk premiums from LatAm issuers that are as fundamentally sound, prudently leveraged, and financially robust as their peers in developed markets (where sovereign ratings are higher). It is worth mentioning that companies in LatAm have prudentially done their borrowing in US dollars in recent years. Most of those companies by now have a global footprint and generate a solid percentage of their revenue in US dollars. Moreover, many companies hedge their interest payables and total debt loads in US dollars.
As a portfolio manager, what are the fundamental attractions of investing in LatAm corporate bonds, in your opinion?
In recent years, companies’ balance sheets have become stronger and their ability to generate free cash flow has improved while overall indebtedness has remained stable or has diminished. This leverage-free growth is a highly desirable attribute, while the maturity profile is also favorable in the sense that short-term debt accounts for a comparatively small proportion of the total debt ratio, meaning that the refinancing risk is low. In addition, by virtue of LatAm being the oldest and most mature segment of the EM bond universe, issuers typically benefit from strong management teams with a proven track record in handling crises. Furthermore, investors in LatAm debt are relatively sophisticated and demand high levels of transparency, meaning that quarterly reporting is standard (unlike in other geographical components of the EM universe). All of this contributes to a very robust high-yield sector offering superior compensation for astute risk absorption – this is an area in which we particularly seek to add value on behalf of our investors, with our strong expertise being supported by a collaboration with Lucror Analytics, an independent research firm specializing in the high-yield credit segment. In overall terms, the LatAm universe provides active managers with a wide range of idiosyncratic opportunities, creating the potential to generate a solid investment performance with broad diversification.
The LatAm universe provides active managers with a wide range of idiosyncratic opportunities, creating the potential to generate a solid investment performance with broad diversification.
Which sectors are of particular interest in the prevailing environment?
The LatAm region is renowned for its high prevalence of natural resources and accounts for a significant proportion of global exports. Unlike the cases in Russia and the Middle East, for instance, the depth of LatAm resources spans a diversified range of commodities in addition to oil, including gold, iron ore, copper, soybeans, pulp, paper, and proteins. With regard to proteins, food consumption has proven to be crisis-resistant. There is currently excess consumer demand for meat and meat products due to temporary factory closures, droughts in recent months, the adverse impact of African swine fever, and reaccelerating consumption in China. Brazilian meat producers with worldwide reach are partially meeting this demand overhang and are profiting accordingly. Every crisis has its winners, and those winners are profiting from the current market environment.
Why should investors consider adding LatAm corporate bond exposure to their portfolios?
In the context of COVID-19, periods of market stress have typically provided lucrative entry points for those brave enough to take the plunge, and LatAm offers an arena in which many issuers now have a global footprint, generating a solid percentage of their revenue in US dollars from a cost base in local currency. This is a major advantage during periods of greenback strength when repatriated earnings are magnified by the currency effect. Meanwhile, the higher risk premiums referred to earlier have typically generated higher yields and enhanced carry relative to other corporate bond markets. Capital values invariably fluctuate, but the overall volatility of hard (non-local) currency-denominated issues has tended to be moderate, meaning that total returns have typically been positive on a month-on-month basis translating into high single-digit annualized returns since inception.1 Sharpe ratios (a measure of risk-adjusted returns) are attractive relative to other regions and asset classes, indicating the compelling nature of the investment opportunity.