Emerging market corporate debt stands alone

Companies: Investec

People: Victoria Harling

Victoria Harling, Strategy Leader, Emerging Market Corporate Debt

Insurance investors worry about low overall yields, particularly as their higher yielding pre-quantitative easing portfolios continue to mature. Some insurance investors have sought yield further down the credit rating spectrum or via less liquid asset classes to combat this, while retaining a healthy overall exposure to investment grade. We believe there is an alternative for part of this allocation, hard currency emerging market corporate debt.

Victoria Harling outlines the opportunity for insurance portfolios to include an allocation to emerging market corporate debt, including accessing higher yields, improving fundamentals and diversification from a growing universe. For insurers incorporating an allocation to emerging market corporate bonds there is scope to further optimise the liability matching portfolio or boost the growth portfolio within acceptable capital requirements limits.

 

A significant asset class

The dollar EM corporate debt universe has grown from nearly nothing a decade ago to stand at over US $2 trillion in 2018. Asia has been the main driver of growth, with China not surprisingly playing a key role in expanding and diversifying the asset class. EM corporate debt is larger than US high yield and European high yield, it is a similar size to the EM sovereign dollar universe and can offer the required liability matching attributes an insurer might consider when investing their corporate bond allocation.

Figure 1: EM Corporate debt universe is large enough to stand alone. Source: Bloomberg, Investec Asset Management as at 31.08.2018

 

What might be surprising is that more than 55% of EM corporate debt is investment grade.

In this article we explore:

  • The yield premium that exists in emerging markets,
  • the potential diversification benefit,
  • an assessment of the fundamentals, and
  • the opportunities created by the recent volatility.

 

Persistent yield premium in Emerging Markets

Emerging market corporate debt offers higher yields often at lower durations versus developed market counterparts. Over the last ten years, emerging market investment grade corporate debt has outperformed the US investment grade corporate bond market 98% of the time over rolling five-year periods. The time-period includes many tests for emerging markets, ranging from the Global Financial Crisis, European sovereign debt concerns and the commodity price collapse that impacted emerging markets directly.

Figure 2: Persistent premiums in emerging market investment grade corporate debt (USD). Source: JP Morgan, Bloomberg, 31.08.2018

EM IG Corporate Debt: JP Morgan CEMBI Diversified High Grade Index
US IG Corporate Debt: Bloomberg Barclays US Corporate Index
*Batting average is expressed as a percentage of periods in which EM IG Corporate Debt outperformed US IG.

But can this continue? We believe the best way to assess future fixed income returns over a market cycle is to consider the yield, duration, and potential interest rate environment. Figure 3 provides index level data for US and European investment grade sectors, as well as emerging market investment grade corporates. We believe by incorporating the extra yield generated by emerging market investment grade corporates versus incumbent regions, insurers can better optimise their corporate bond allocations.

Figure 3: Global investment grade options. Source: JP Morgan, Bloomberg as at 31/08/2018

 

A strong diversifier

The EM corporate universe includes 33 countries with investment grade companies.

One of the key attributes to consider when adding a new asset class to a portfolio mix is how it correlates with other asset classes. As can be seen by the table below, which provides a 10-year historical view of correlations across asset classes, emerging market investment grade corporate debt offers additional diversification to other US dollar allocations, but importantly also when the returns are hedged back to EUR.

Figure 4: Correlations to credit allocations. Source: Bloomberg, JP Morgan, BofAML and Investec Asset Management as at 31.08.2018

 

 

 

EM companies and their fundamentals

Emerging market companies on average have maintained better credit fundamentals than their similarly rated developed market peers, as they have needed to maintain resilience during challenging macroeconomic backdrops. Headquartered and operating in emerging markets, these companies are familiar with volatility and have historically had periods when they struggled to finance themselves with longer-term debt. Thus, their short-term debt is higher as a percentage than in developed markets, and their refinancing risks have historically been higher. This has led to a culture of retaining cash while containing leverage. The chart below shows the lower net leverage in emerging market investment grade companies versus developed market peers (using the US as a proxy for global investment grade).

Figure 5: Emerging market investment grade corporate versus US investment grade corporate net leverage metrics. Source: Bank of America Merrill Lynch as at 31.12.17

Most emerging market companies are capped by the rating of their governments. Even when we account for what are often better fundamentals, their geography effectively drags down the rating. Figure 7 compares across all ratings buckets emerging market and US companies net leverage metrics. Emerging market companies once again look better. Investors conversely believe emerging market companies are riskier because of their operating environments – rating agencies account for this – yet premiums exist above developed market peers often for companies that have better credit metrics.

Figure 6: Emerging market investment grade corporate versus US investment grade corporate net leverage multiples by rating. Source: Bank of America Merrill Lynch as at 30.06.18 (earnings date 31.12.17) (x) means as a multiple of EBITDA

 

As the economic crisis hit from 2014 and an emerging market slowdown occurred, leverage increased. However, it continually remained lower than their developed market counterparts. The reality is that the amount of total debt in absolute terms remained reasonably stable, but leverage increased as earnings were challenged. The behaviour of corporates proved particularly bond holder friendly – cutting dividends and capex aggressively, as well as using equity raises and asset sales to contain debt.

 

How can non-USD investors access the EM Corporate asset class?

Although there are a healthy number of emerging corporates that issue debt in euro and other currencies, a well-balanced and diversified allocation to the EM corporate asset class will be largely denominated in USD. For investors requiring a hedged allocation, the approach to hedging can have a significant impact on projected returns and can also reveal opportunities. For GBP and EUR investors, even after considering hedging costs and anticipating further rate rises in the US, there are opportunities to lock-in attractive yields in EM corporates over and above domestic bonds with similar ratings.

Yield to worst – EUR Hedged

Yield to worst – GBP Hedged

Figure 7: Investment Grade Corporate Allocations. Source: Bloomberg, JP Morgan, BoAML and Investec Asset Management as at 31.08.2018

 

 

Opportunities arising from recent volatility

As the Federal Reserve tightens financial conditions, investors have turned to some of the weaker emerging markets to assess which countries and companies could struggle to repay their dollar-denominated debt, particularly if generating a large part of their revenues in a weaker local currency. We have naturally seen the recent currency devaluations in both Turkey and Argentina, increase concerns over corporate accessibility to USD and credit fundamentals for companies directly impacted.

Importantly, when EM currencies comes under pressure this can often improve the competitiveness of EM companies as their local cost bases also shrink. Often, the sell-off in emerging corporate bonds can reach extreme levels which can provide value opportunities for insurers looking to allocate to the asset class.

The EM investment grade corporate universe has been well insulated from the bulk of recent volatility, however, it is our firm belief that a dedicated team is required who by carefully researching the companies in the universe can build a well-diversified and robust portfolio of emerging corporates to navigate through these economic events.

 

Conclusion: an attractive proposition for long-term, insurance liability investing

We believe that insurers allocating to emerging market corporate debt, taking advantage of its higher yields, improving fundamentals and diversifying via its growing size are better placed to optimise their corporate bond portfolios.

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