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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. BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary. WP/Feb2017/3-2-17/BR