Corporate bonds have a long tradition in developed markets, with a large investor base across the credit rating spectrum. Over the past decade, corporate bonds of issuers based in emerging markets (EM) have started to catch up – turning into a mainstream asset class. They offer investors a powerful diversification element as well as strong potential for outperforming the wider bond market, and are therefore worth a closer look.
In the roughly 10 years since the financial crisis, the emerging market corporate bond asset class (in hard currency) has grown by about 600 per cent. The asset class has now surpassed both the US high yield bond market and the sovereign hard currency EM debt market, accounting for around 20 per cent of the global corporate bond market. This growth is not yet reflected in most investors’ portfolios.
Notwithstanding well-flagged incidents of economic and political volatility at the country level – which we increasingly see across developed markets as well – emerging markets continue to enjoy superior GDP growth. For example, the IMF estimates growth rates for emerging markets will remain above 4 per cent for the coming years, while developed economies are likely to grow at below 2 per cent. This growth clearly benefits companies active in these markets. Of equal importance, however, and possibly coming as a surprise to many investors, is the fact that emerging markets companies are in strong financial health: on average they have less leverage compared to developed market corporates. As such, their bonds pay more for the same level of leverage (as measured by net debt to earnings before tax, depreciation and amortisation) across all rating segments. For example, US companies rated BBB pay 39 basis points per turn of leverage, versus 76 basis points in emerging markets. From a risk perspective, this is a more meaningful comparison than just comparing headline index yields.
Corporate bonds also offer diversification benefits. Although sovereign bonds have been the traditional way of gaining access to the higher returns available in emerging markets, their downside is that they are very largely driven by macroeconomic or ‘top down’ country developments, as well as external factors like the US dollar. Corporate bonds are a far more flexible opportunity set, as the investment universe gives access to a diverse range of sectors and heterogeneous companies. The JP Morgan Emerging Market Bond (EMBI) Index for sovereign issuers comprises a total of 170 different issuers across 73 countries. By contrast, the JP Morgan CEMBI Broad Diversified Index for corporate issuers comprises 679 issuers across 71 countries. Some sectors are more exposed to domestic factors, such a rising consumer demand, while others are geared towards external factors, such as commodity prices. This allows positioning to take advantage of a given country’s particular competitive advantage; or, currently, with a view to minimising the detrimental effects of the ongoing US-China trade dispute. It is additionally also an area where investors can gain an edge by studying company-specific fundamentals and where on-the-ground research makes a difference.
The uncertain interest rate environment also favours emerging market corporate bonds. From a risk perspective they are usually superior to their sovereign bond peers in periods of rising interest rates due to their much shorter duration (typically around 4.5 years versus 6.5 for emerging market sovereigns). This means that they are less sensitive to rate movements. This proved to be the case last year, when emerging market corporates corrected much less than emerging market sovereigns. Looking forward, if rates remain unchanged or move even lower, emerging market corporates should continue to benefit from low default rates and solid profitability.
When choosing emerging market corporate debt it makes sense for foreign investors to stick to hard currency bonds (issued in dollars or euros, as opposed to local currencies). The local currency universe is still in its infancy, with the very limited supply and liquidity often resulting in wide bid-ask spreads and distorted pricing. Hence, hard currency investors are taking one additional variable out of the equation, one which would have diminished the positive returns from underlying investments over the past few years, when local currencies have generally been weaker against the US dollar.
Over the past decade, bond markets everywhere, but particularly in emerging markets, have seen massive structural change. In line with their growing political and economic impact, emerging markets merit greater attention from investors.
Theo Holland is senior portfolio manager at Fisch Asset Management, a member of The Gulf Bond and Sukuk Association