Investment Themes Hard-currency corporate bonds from emerging markets
Emerging market corporate bonds denominated in hard currency are playing an increasingly significant role on the global bond market. There are several reasons why investments in this asset class merit closer inspection.
Emerging markets are becoming an increasingly important part of the global landscape. For example, emerging economies now account for considerably more than half of the global economic output1. In comparison with the developed world, emerging nations are posting substantially more robust growth, while their gross debt ratios as a proportion of GDP – at an average of 53% – are significantly lower than those of their developed world counterparts, which average some 103%. This positive trend on the macroeconomic front looks set to be maintained, creating a fertile environment for corporate bonds in these nations. This should continue to open up exciting opportunities for investors.
Positive rating trend continues
Looking back, it is evident that emerging markets have exhibited a positive rating trend in the global context. While positive macroeconomic factors have helped in this regard, so too has the general willingness to implement reforms. Emerging markets have already undergone various economic cycles and know what it means to withstand a crisis. Numerous emerging economies have implemented key reforms to strengthen their systems and are likely to continue to do so going forward. As a result, the positive rating trend should remain intact in future.
Focus on hard-currency corporate bonds
The fundamental factors outlined above provide the essential bedrock for the respective countries’ corporate bonds. Rating upgrades at the country level also benefit fundamentally strong companies that are strategically relevant and have close links to the state. Owing to the methodology used by the rating agencies and the country ceiling, corporates cannot generally be awarded a rating higher than the respective sovereign. However, in the case of businesses with global operations or large firms with very strong fundamentals, the rating agencies exercise a certain degree of discretion and may award the company in question a higher – by a limited number of notches – rating than the respective country. This in itself is especially likely to pique investors’ interest. If certain companies were headquartered in a developed nation with a higher credit rating than that of their own developing market, they would be given a correspondingly better rating. As a result, investors can benefit from the higher spreads of emerging market corporates with strong fundamentals. Demand has indeed picked up in recent years, while on the supply side the market has posted strong growth and the diversification in the number of issuers, sectors and maturities has continually increased. In the past, many emerging market companies refinanced their bank loans on the international capital market and have since been active on the primary market. The market in hard-currency corporate bonds from emerging nations is now bigger than that of European or US high-yield issuers. If we include emerging market hard-currency government bonds as well as corporate paper, the volume runs to half that of the US investment-grade market and actually exceeds the European investment-grade universe.
Compared to their developed world peer group, the performance of emerging market corporate bonds is solid. Looking at this from an idiosyncratic credit perspective, it is useful to compare net debt (gross debt minus liquid funds) versus one year’s EBITDA (earnings before interest, taxes, depreciation, and amortization). The lower the value, the better debt is covered by operating profits. On account of their market size, US companies represent the developed world. The comparison shows that emerging markets hold up well. While issuers of corporate bonds from emerging markets have average net debt of 1.5x, the corresponding factor in their US peer group is 2.6x. A comparison within the individual rating segments reveals that emerging market corporate bonds exhibit better ratios across all rating buckets. Furthermore, corporate bond issuers from emerging markets have steadily deleveraged their balance sheets since the last “energy crisis” in 2015 and 2016. Latin America is the standout region in this regard. Brisk use is being made of the positive market environment at present to obtain refunding for the sole purpose of enhancing the maturity profile. Some issuers are already refinancing expiries with a residual maturity of five years. As far as the overall market in emerging nation corporate bonds is concerned, the fundamental situation is expected to remain intact. In addition, we expect defaults to remain low in future thanks to the solid maturity profile.
Investments in corporate bonds from emerging markets currently have a yield to maturity of 5.1%, while the spread is 3.4%. Duration stands at 4.5, while the average rating is BBB– (source: JPM, October 21, 2019). The current valuation is above the average of the past three years, while it is in line with the five-year average. As fundamentals have certainly improved over this period, valuations are actually attractive at present. Valuations also look appealing when compared to the developed world peer group. Turning to the spreads of emerging market corporate bonds, both investment-grade and high-yield issuers offer a solid pickup versus their respective peer groups. This is likely to be of even greater interest as the average duration of the developed world peer group tends to be higher2.
Outlook for the end of 2019
Since 2002, emerging market corporate3 bonds have generated a solid performance of +7.2% (annually in US dollars), with corporate bonds from Latin America topping the performance table at +8% (annually in USD). As things stand, sentiment toward investments in emerging market corporate bonds remains intact thanks to good corporate fundamentals, accommodative monetary policy on the part of central banks across the world and appealing valuations. That said, the corporate bond market is not immune to volatile times, especially when the causes are of a political nature. It remains essential to keep a very close eye on the market environment and performance with a view to identifying winning companies. Carefully considered positioning as well as an active and robust investment strategy are essential prerequisites for success in this asset class.
Emerging market investments usually result in higher risks such as political, economic, credit, exchange rate, market liquidity, legal, settlement, market, shareholder and creditor risks. Emerging markets are located in countries that possess one or more of the following characteristics: a certain degree of political instability, relatively unpredictable financial markets and economic growth patterns, a financial market that is still at the development stage or a weak economy.