Download Emerging Market Corporate Debt: An Attractive Investment Opportunity

March 2017
Prakash Gopalakrishnan
Senior Credit Analyst of BNY
Mellon Investment Management
Singapore Pte. Ltd
Emerging Market Corporate Debt:
An Attractive Investment
Opportunity
This investment grade-rated, geographically-diversified asset class offers investors attractive
opportunities for yield without excessive levels of risk. We believe this opportunity will become
increasingly compelling as global commodity prices stabilize, EM economies grow and corporate
fundamentals improve.
The emerging markets USD corporate debt asset class has grown over years along with the steady
expansion of the private sector, the growth of the global economy, the deepening of international
and local capital markets, and easy central bank monetary policies. These factors have enabled EM
corporations to diversify their funding sources and support robust issuance that offers attractive
returns to investors. Today, according to JP Morgan, the EM corporates asset class, as measured by
CEMBI broad index is roughly similar in size to EM sovereigns and quasis, as measured by EMBIG, and
to US high yield.
Current Index Market Cap (USDbn)
6000
5000
4000
3000
2000
1000
0
EMBIG
CEMBI Broad GBI-EM Global JULI ex EM (US JPM HY (US
Diversified
HG)
HY)
Euro HG
JPM Euro HY
(Euro HY)
Source: JPM Index Movers as of February 17, 2017
The EM Corporate Bond Universe Is Investment Grade Rated
The EM corporate universe is made up of investment grade-rated bonds, with countries’ credit ratings
ranging from AAA-rated Singapore and Hong Kong to B- rated Argentina, Ghana and Egypt. The
benchmark CEMBI broad index has an average credit quality of BBB-/Baa3, despite the downgrades
of Russia and Brazil in recent years. The credit quality of the index reflects the growth in investment
grade rated bond issuance over time, particularly from Asia. TThe index has 59% of its weight in
investment grade corporates and 41% of its weight in non-investment grade corporates.1
1
As of February 27, 2017
2
Annual Bond Issuance
Middle East & Africa
Latin America
Emerging Europe
Asia
400
300
Steady issuance at
attractive spreads
is likely to keep the
EM corporate asset
class growing
200
100
0
2010
2011
2012
2013
2014
2015
2016
2017F
Source: JP Morgan CEMBI Monitor December 2016
EM Corporates Offer An Attractive Yield Pick-Up Over Their Respective Sovereigns And
Developed Market Peers
EM corporates offer attractive yield pick-up compared to their home countries’ external sovereign
bonds and those of their emerging market peers. As of February 24, 2017, the average spread to
sovereign was 94bp.2 While this has compressed compared to historical levels, it still offers 1.9 times
the compensation of sovereign spreads.
Composite Index Spread
EMBI Global
CEMBI Broad
US HG ex-EM
US Domestic HY
1000
800
600
400
200
Feb-17
Dec-16
Oct-16
Jun-16
Aug-16
Apr-16
Feb-16
Dec-15
Oct-15
Jun-15
Aug-15
Apr-15
Feb-15
Oct-14
Dec-14
Jun-14
Aug-14
Apr-14
Feb-14
Oct-13
Dec-13
Aug-13
Jun-13
Apr-13
Feb-13
Dec-12
Oct-12
Aug-12
0
Source: JP Morgan as of February 17, 2017
Compared to US high grade corporates, EM corporates offer an attractive 123bp pickup in spread3,
which we believe compensates investors for the three notch difference in average credit quality
between the two. Additionally, EM corporates have lower duration at 4.6 years than US HG corporates
with duration of 7.3 years4. Compared to US high yield corporates with an average rating of B+,
the EM corporate high yield (average rating of BB-) spread is 30bp tighter. However, this is due to
significant differences in their composition. US high yield has roughly 40% of its weight in the energy
sector compared to 25% in EM corporates and much of that reflects majority-state owned entities.
The EM Corporate Universe Is Well Diversified By Country And Sector
Diversification is one of the benefits of investing in EM corporate bonds. The CEMBI broad index
contains 1,195 issues from 549 issuers domiciled in 50 countries around the globe. This creates the
potential for active managers to obtain alpha based on fundamentals and value which may differ by
country and/or segment. While China has grown to become the largest constituent of the index, much
of the weight is made up of majority-state owned issuers that benefit from the sovereign’s strong
credit profile. Additionally, while the oil and gas and metals and mining sectors account for roughly
Source: JPM EM Corporate Spread to Sovereign Report as of February 27, 2017
Source: JP Morgan as of February 27, 2017
4
For JULI (US High Grade, ex-EM credits)
2
3
3
25% of the overall index, the issuers in this industry tend to be global leaders with low cost positions
that enable them to withstand low commodity prices. Furthermore, these corporates also tend to be
majority state owned, which means that on average, they benefit from potential support from their
respective sovereigns.
CEMBI Broad Index by Sector and Country
Real Estate, 6.7%
Metals & Mining,
6.7%
Utilities, 7.1%
1195 issues from
549 issuers in 50
countries underpin
the diversity of the
EM Corporate asset
class
Consumer, 6.7%
TMT, 11.6%
Industrial, 5.1%
Diversified, 2.9%
Infrastructure, 2.0%
Pulp & Paper, 0.8%
Transport, 0.4%
Oil & Gas, 18.2%
Financial, 30.4%
Others (40 countries),
20.6%
China, 20.7%
Colombia, 2.8%
Turkey, 3.1%
Israel, 3.2%
Brazil, 14.9%
Korea, 3.5%
UAE, 3.9%
India, 5.3%
Hong Kong, 6.8%
Russia, 8.1%
Mexico, 7.1%
Source: JP Morgan as of February 17, 2017
The Pickup In EM Growth Means Corporate Fundamentals Are Likely To Bottom Out
Standish expects emerging markets economic growth to rise to 4.5% in 2017, up from an expected 4%
in 2016 and 3.6% in 2015. This sets the backdrop for corporate fundamentals to stabilize and improve.
Net leverage and interest cover, two important measures of credit quality, have already shown signs
of stabilization5, raising the likelihood that fundamentals have bottomed out and are set to improve
with the broader economic rebound.
Net Leverage (ex Real estate/defaults)
Asia
EM Europe
Latin America
ME / A
EM Corps Global
3.0x
2.5x
2.0x
1.5x
1.0x
0.5x
0.0x
2008
2009
2010
2011
2012
2013
2014
2015
Source: JP Morgan as of June 30, 2016
Interest Coverage
5
Source: JP Morgan. Most data based on 1Q 2016.
EM IG (ex. 100% quasis, Real Estate)
14.0x
EM HY (ex. 100% quasis, Real Estate)
LTM
0.5x
0.0x
2008
4
2009
2010
2011
2012
2013
2014
2015
LTM
Source: JP Morgan as of June 30, 2016
Interest Coverage
EM IG (ex. 100% quasis, Real Estate)
EM HY (ex. 100% quasis, Real Estate)
14.0x
12.0x
10.0x
8.0x
EM corporate credit
fundamentals are
bottoming
6.0x
4.0x
2.0x
0.0x
2008
2009
2010
2011
2012
2013
2014
2015
LTM
Source: JP Morgan as of June 30, 2016
EM Corporates Have Relatively Lower Leverage And Higher Spread vs US Peers
EM corporates have lower leverage than their US peers with similar ratings. In addition, spread
compensation per unit of leverage is higher for EM corporates than for their US peers. While leverage
has increased and spread compensation has decreased recently, EM corporates offer a better balance
between risk and reward than similarly rated US corporates.
EM Corporate Leverage Is Lower..
Global EM Gross Leverage (x)
US Gross Leverage (x)
4
3
2
1
0
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: Merrill Lynch, as of January 3, 2017
…While Spread For Unit Of Leverage Is Higher
Global EM Spread per turn of Leverage (bps/x)
800
US
600
400
200
0
2008
2009
2010
Source: Merrill Lynch, as of January 3, 2017
2011
2012
2013
2014
2015
2016
5
EM Corporates Have Comparable Or Lower Defaults Than Their Global Peers
Leverage (x)
10
US
8.00
EM
5.67
5.66
5
3.30
3.60
3.25
2.42
2.37
0
B
BB
BBB
A
Source: Merrill Lynch as of June 30, 2016
Spread Per Turn Of Leverage (bps/x)
US
120
100
EM
97 bps/x
89 bps/x
76 bps/x
80
60
60 bps/x
50 bps/x
48 bps/x
42 bps/x
41 bps/x
40
20
0
B
BB
BBB
A
Source: Merrill Lynch as of June 30, 2016
The relative resilience of credit risk in EM corporates reflects their lower default rates since the global
2008 financial crisis compared with US and global corporates. We believe that a primary reason for
the lower default rate is the fundamental higher credit quality of issuers that is reflected in their 60%
IG rating.
Speculative Grade Default Rate
2016
2015
2014
2013
2012
2011
2010
2009
Emerging Markets
3.6%
3.07%
1.05%
2.00%
2.62%
0.47%
1.55%
5.46%
US
5.1%
2.83%
1.60%
2.17%
2.64%
2.13%
3.40%
11.72%
Europe
1.9%
2.10%
0.97%
3.43%
2.24%
1.59%
1.01%
8.67%
Global
4.1%
2.75%
1.43%
2.29%
2.57%
1.83%
2.99%
9.88%
Source: S&P: Default, Transition, and Recovery dated Dec 22, 2016 & January 26, 2017
Currency Risk Remains But Is Significant Only In Parts Of The Asset Class
While EM currency performance improved in 2016, currency risk remains integral to the asset class.
Many corporates have already borne the brunt of currency volatility since mid-2013 with a moderate
increase in leverage. About 12% of the sector is domiciled in countries with current account surpluses
and floating foreign exchange regimes. While potential shifts in trade patterns may pose a threat to
these currencies, the issuers in these countries typically gain from weaker currencies thus providing
a natural credit hedge. Twenty one percent of the issuers are in China which has a managed currency
regime and 7% are in Hong Kong which has pegged its currency to USD. The central banks in these two
countries have sufficient foreign exchange reserves to defend their currency regimes, thus potentially
alleviating the impact of not having floating regimes.
With better credit
metrics vs. DM, EM
Corporates have
had lower defaults
%
%
%
%
%
%
%
%
%
%
%
6
The GCC countries with pegged currencies account for about 7% of the issuers. While they
face longer-term challenges if oil prices stay low, they also have sufficient reserves to defend
their currencies in the near-term. Of the countries that were tagged as the “fragile five” during
the taper tantrum in 2013, India and Indonesia have improved their currency defenses and
the outlooks for their currencies remain stable despite potential rate hikes by the Fed. Russian
corporates have been supported by the central bank providing foreign exchange liquidity
support or benefitting from their exports.
Currency and
commodity risks
are integral to asset
class; EM corporates
are positioned to
deal with these risks
The financials, metals and oil and gas sectors, which account for 55% of the universe, have
natural or currency hedged positions. This leaves only domestically focused sectors such as
utilities, real estate and consumer open to major currency risks. Even some of these issuers’
foreign exchange risks are partially hedged or economically passed through, which leaves
only a subset of the issuers exposed to material FX risks. EM Corporates - FX Risk By Country
Others 20%
South
Africa
Indonesia 1% 1%
Current A/C
surplus 12%
Russia 8%
Turkey 3%
China 21%
Indonesia 1%
India 6%
Brazil 15%
GCC with peg 7%
Hong Kong 7%
Source: JP Morgan, as at December 30, 2016
Commodity Exposure Also Remains A Risk But Performance Reflects Better
Relative Fundamentals
EM corporates have significant exposure to commodity prices. However, EM corporate bonds
in the oil and gas sector have outperformed developed market peers. Many firms are majority
state owned, which has lent support to their credit profiles. EM corporate bonds in the metals
and mining segment, accounting for only 6.8% of the universe, have been more volatile but
have recovered from their underperformance with improvement in commodity prices since
the lows of the year.
Spread Performance (Base = 100 as of December 31, 2014)
CEMBI Broad metals & mining IG
JULI ex-EM metals & mining
CEMBI Broad oil & gas IG
JULI ex-EM energy
120
110
100
90
80
Source: JP Morgan as of December 31, 2016
Spread Performance (Base = 100 as of December 31, 2014)
CEMBI Broad metals & mining HY
CEMBI Broad oil & gas HY
140
US HY metals & mining
US HY energy
Source: JP Morgan as of December 31, 2016
7
Spread Performance (Base = 100 as of December 31, 2014)
CEMBI Broad metals & mining HY
CEMBI Broad oil & gas HY
US HY metals & mining
US HY energy
140
120
100
80
60
Source: JP Morgan as of December 31, 2016
Appendix
Total Return History By Major Fixed Income Asset Classes
CEMBI
Total Return in % Broad
2004
10.3
2005
6.3
2006
6.5
2007
3.9
2008
-16.8
2009
37.5
2010
12.5
2011
3
2012
15.2
2013
-1.3
2014
3.6
2015
1.2
2016
10.8
Annualized return
6.5
Annualized volatility
8.4
Sharpe Ratio
0.6
JULI Maggie
6
7.7
1.4
3.9
3.7
1.1
5.8
0.5
0.8
0.1
18.2
16
9.4
4.8
8.6
3.1
9.6
12.4
-0.7
1.8
8
8.3
0.3
-0.4
6.1
4.3
5.8
4.8
5.4
3.3
0.8
0.9
Source: JPM Morgan CEMBI Monitor December 2016
JPM
JPM Euro
EMBI Global
HY
11.5
3.1
11.5
2.9
-26.8
58.9
15
5.7
16.2
7.4
1.7
-4.3
18.3
7.9
9.2
0.7
HY
14
4.6
9.7
-1.3
-34.9
73.4
14.8
1.7
27.8
11.8
6.1
1.4
9.8
8.4
10.5
0.6
Diversified
11.6
10.2
9.9
6.2
-12
29.8
12.2
7.3
17.4
-5.3
7.4
1.2
10.2
7.7
8.4
0.7
JACI
7.3
5.4
-9.8
28.3
10.6
4.1
14.3
-1.4
8.3
2.8
5.8
6.5
7
0.7
GBI-EM
US
Global Div
23
6.3
15.2
18.1
-5.2
22
15.7
-1.8
16.8
-9
-5.7
-14.9
9.9
6.2
12.4
0.4
Treasury
3.7
2.9
3.1
9.2
14.3
-3.8
6.1
9.9
2.2
-3.4
6.1
0.9
1.1
3.9
4.4
0.5
Standish Mellon Asset Management Company LLC
Boston • Pittsburgh • San Francisco
Standish Mellon Asset Management (UK) Limited
www.standish.com • [email protected]
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not
provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not
intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These
views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed
by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of
such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past
performance is no indication of future performance.
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WP/Feb2017/3-2-17/BR