Download Focus on emerging market corporate debt_Insights_r4

For professional investors only* – not for retail use or distribution
INSIGHTS
Focus on emerging market
corporate debt
Themes in bond investing
June 2009
June 2012
PLEASE VISIT
jpmorgan.com/assetmanagement
for access to all of our insights
publications.
IN BRIEF
Despite the global uncertainty, emerging market debt has managed to hold on
to positive returns so far in 2012. In this paper, Alain Defise examines the
macroeconomic backdrop and the potential developments in the coming
quarter, assessing their likely impact on emerging market debt. He then
focuses on emerging market corporate debt, which has been among the bestperforming fixed income sub-asset classes over the year to date.
Emerging market debt to keep muddling through
Despite a turbulent May for risk assets, caused by widespread risk aversion,
lowering of global growth forecasts and fears of further European peripheral
stress, emerging market (EM) debt assets have managed to hang on to positive
returns over the year to date.
Our main expectation is for EM debt to continue to muddle through in the third
quarter, although we could see a gradual rebound in the event of any significant
policy response. This tepid outlook is underpinned by expectations for sub-trend
global growth, with our proprietary leading economic indicators pointing towards
weaker growth over the next one-to-three months (see Exhibit 1).
Following a strong rebound at the end of the fourth quarter of 2011, the regional
indicators have turned just below the trend growth level. It is clear that emerging
markets are not decoupling from developed markets, primarily due to trade
linkages.
Global growth is expected to be below trend
1
0
-1
FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION
Oct-11
Mar-12
Dec-10
May-11
Jul-10
Feb-10
Apr-09
Source: Bloomberg, J.P. Morgan Asset Management. As of June 2012.
Sep-09
Jun-08
Nov-08
Jan-08
Aug-07
May-06
Jul-05
Dec-05
Feb-05
Sep-04
Apr-04
-3
LATAM
Oct-06
ASIA
Mar-07
EMEA
-2
Jun-03
Senior Portfolio Manager
Emerging Markets Debt
2
Nov-03
Alain Defise
3
Jan-03
Standard deviation around trend growth
Exhibit 1 – Regional average proprietary leading indicators
Focus on emerging
market
corporate debt
February
2012
Corporate bonds and European sovereign debt after the LTRO
Policy response is expected in emerging and developed
markets
Given expectations for slowing global growth, falling commodity prices and
powerful base effects, inflation expectations are expected to remain depressed,
with core inflation remaining well anchored. However, deflationary effects may
be limited in some countries (e.g., Brazil, Mexico and Hungary) due to currency
weakness.
We expect to see policy responses in the coming quarter from both developed
and emerging markets. Central banks in emerging market countries have the
ability to provide stimulus in this weaker environment given their proactive
interest rate rises in 2010 and 2011 and the generously high real interest rates
in certain countries (e.g., Brazil and China).
Range trading set to continue, with chance of a gradual
recovery
The extent and size of the policy response remains uncertain. Hence, in our
scenario analysis (see Exhibit 2) we expect the market to rotate between risk
off (scenario 1) and range trading (scenario 2) – the latter due more to covering
short positions than deployment of new cash. Compared with the second
quarter, this range trading is likely to become more violent (i.e., with wider
ranges) given thinner volumes and lower liquidity.
Exhibit 2 – Expectations for the coming months
Probability
10%
20%
70%
Phase
Risk on triggered
by policy action
Gradual rebound
Muddle-through – Gradual slowdown
Market Dislocation
SCENARIO 4
SCENARIO 3
SCENARIO 2
SCENARIO 1
Phase
Growth slowing
Recession fear
Rotating
GROWTH
Accelerating
Growth turns up
Low but close to
expectations
INFLATION
Up, driven by
commodities
Flat/under control
Moderate
downward
pressure
Downward
pressure
Deflation scare
POLICY
RESPONSE
Liquidity &
capital injection
On hold
On hold (selective
easing)
Easing (selective
responses)
Late co-ordinated rate
cuts, quantitative
easing, political action
RATES
Jump &
steepening
Flatter EM bias
Flattening bias
Steepening bias
U.S. Treasuries
MARKET
Risk on (Short
rates & duration,
FX, HY)
Positive (HY, FX,
local currency
corporates)
Range-trading (IG
corporate,
selective FX, back
end rates)
Risk off (IG
sovereign, front
end rates)
Safe haven (USD)
Liquidity response
Significant, powerful coordinated policy response
Source: J.P. Morgan Asset Management. This information reflects J.P. Morgan Asset Management's opinion and goals and is subject to change.
2 | Focus on emerging market corporate debt
Focus on emerging
market
corporate debt
February
2012
Corporate bonds and European sovereign debt after the LTRO
EM corporate debt has outperformed in 2012
Exhibit 3 – EM versus other indices – 2012, through May
CEMBI Broad High Yield
U.S. High Yield
CEMBI Broad
S&P 500
U.S. High Grade
EMBIG
U.S. Treasuries - Intermediate
GBI-EM Global Diversified
ELMI+
EM Equities
Commodities
6.3%
5.2%
4.8%
4.2%
4.0%
3.7%
2.0%
1.3%
-0.2%
-0.6%
-10.6%
Source: J.P. Morgan Asset Management, Bloomberg, As of June 2012.
We are hopeful that policy responses, particularly from
developed markets, may allow a move from our core
muddle-through scenario to a gradual rebound (scenario 3)
towards the end of the quarter. However, we cannot
discount a dislocation phase from the scenarios mentioned
previously for the quarter, particularly given the significant
event risks resulting from the eurozone debt crisis. We
would expect such a dislocation to take the form of a nasty
phase of negative price action that could lead to significant
coordinated policy response, both monetary and,
importantly, fiscal. This would have the potential to kickstart a major risk-on rally (scenario 4).
Fundamentals remain strong
EM corporate fundamentals will undoubtedly be somewhat
challenged by the current macro backdrop. There has
already been some evidence of this in the most recent
quarterly corporate earnings releases, particularly from
China, where industrials are suffering margin compression
as a result of higher costs and revenues are coming under
some pressure.
However, after acknowledging the potential for some
deterioration, it is important to emphasise just how strong
fundamentals currently are.
Emerging market corporate debt
EM corporate high yield debt has been the best-performing
fixed income sub-asset class so far this year, with
investment grade not far behind (see Exhibit 3). Broadly
speaking, the period can be split into two phases: a phase
of strong outperformance in the first four months of the
year and then a phase of consolidation in May’s
turbulence. However, even in May, EM corporate debt was
surprisingly resilient.
The outperformance of EM corporate debt has been
driven, in part, by the strong fundamentals of emerging
market companies. But given the macro environment, can
we expect this strength to persist?
3 | Focus on emerging market corporate debt
Compared with their history, EM corporate issuers have
high cash balances as a percentage of their total debt. In
fact, compared with their peers in the U.S., both
investment grade and high yield EM companies have
higher cash balances and lower net leverage, yet EM
corporate debt yields are significantly higher than those of
similar quality developed market corporates.
The premium on EM corporates is often justified by the
explanation that they are significantly more volatile.
However, on the investment grade side, emerging market
corporates are not dramatically more volatile than their
U.S. peers (see Exhibit 4A).
High yield does still tend to be more volatile, particularly in
periods of broad market stress, when spreads on EM
corporate high yield tend to overshoot as a result of risk
aversion (see Exhibit 4B). We believe, though, that this is
driven by the difference in the investor base for high yield
in emerging markets versus the U.S., rather than being a
reflection of fundamentals.
Focus on emerging
market
corporate debt
February
2012
Corporate bonds and European sovereign debt after the LTRO
EM versus U.S. corporate volatility and spread ratios
Exhibit 4A: Volatility and spread ratios in
investment grade
Exhibit 4B: Volatility and spread ratios in high yield
Source: Bank of America, May 2012.
EM corporates are still good value
Despite their outperformance so far this year, EM
corporate bonds continue to offer good value, particularly
in the investment grade sector. Investment Grade EM
corporates trade at a premium to their U.S. peers, despite
higher ratings and a shorter average duration.
High yield EM corporates, too, trade at a significant yield
premium to U.S. high yield, although default rates and
recovery rates are similar. The credit cycle has peaked,
with the upgrade to downgrade ratio fading, but we are
not revising our default rate expectations at this stage.
We still expect defaults of around 3% this year, a level
that is largely priced into the market. Fundamentals
remain solid and more than 80% of the high yield
investment universe has a stable or positive rating
outlook. In the investment grade sector, too, the vast
majority of issuers (88%) have positive or stable ratings
outlooks (see Exhibit 5).
In recent years, many companies have taken advantage of
the appetite for new issuance to roll over their debt and
extend their maturity profiles, reducing refinancing risk for the
coming years, which would be beneficial for valuations. Also
positive is the fact that the appetite for new issuance has not
disregarded fundamentals. Rather, the market has become
more disciplined, so that even in the first quarter, when
demand for corporate credit was very high, a number of new
issuers were unable to find buyers as investors continued to
focus on quality.
Exhibit 5 – Global emerging market rating outlook
Positive
10%
Negative
12%
The new issuance pipeline is robust
The EM corporate bond market is growing rapidly and, at
USD 800 billion, is now bigger than the EM sovereign
market. It is one of the only fixed income sub-asset
classes in which we expect positive net issuance this
year, as strong issuance in Asia and Latin America
offsets weakness in Europe, the Middle East and Africa.
New issuance is positive because it increases not only
the size of the market but also the diversity, in terms both
of sectors and of single issuers. Issuance is also a good
source of liquidity, helping to drive inflows into the
asset class.
4 | Focus on emerging market corporate debt
Stable
78%
Source: Deutsche Bank, May 2012.
Focus on emerging
market
corporate debt
February
2012
Corporate bonds and European sovereign debt after the LTRO
Conclusion
Global growth is expected to weaken somewhat in the
coming months, which is likely to lead to some form of
policy response from central banks. With the extent of
any policy support unknown as yet, we expect EM debt
to remain range bound.
Despite this backdrop, the secular case for targeted
exposure to EM corporate bonds remains compelling,
based on the solid macro backdrop for emerging
markets, as well as the stronger underlying credit
fundamentals and higher yields of many EM corporate
bond issues relative to similarly rated bonds issued by
companies in developed markets. The strong new
issuance calendar should also improve the liquidity of
EM corporate bonds. These factors will continue to help
the asset class, which we believe means that EM
corporate debt will become a more integral part of
investor portfolios.
5 | Focus on emerging market corporate debt
Alain Defise is the lead portfolio manager for Corporate
Emerging Markets Debt. In this role, Alain is responsible
for identifying credit opportunities and managing
corporate exposures in emerging market portfolios. Prior
to joining the firm in October 2009, Alain spent nine
years at Fortis Investments, holding various corporate
credit roles in London, Paris and Brussels. Most recently,
Alain served as a senior portfolio manager within
Emerging Markets Fixed Income, managing corporate
allocations across a range of emerging market bond
funds. Before this, he worked as a senior credit analyst,
focusing on the high yield market, and as a credit
analyst, specializing in investment grade corporate debt.
Previously, Alain spent four years as a financial control
analyst at Citigroup (Brussels). Alain holds a master’s
degree in business engineering from the Ecole de
Commerce Solvay (Belgium) and a diploma in finance
analysis from the European Federation of Financial
Analysts (EFFAS).
Focus on emerging market corporate debt
“Professional Investors” corresponds to professional clients and eligible counterparties as defined within the European Union Directive 2004/39/EC on
Markets in Financial Instruments (MiFID).
This material is intended to report solely on the investment strategies and opportunities identified by J.P. Morgan Asset Management. Additional information is
available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions
and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as
an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Asset Management and/or its affiliates and employees may hold a position or
act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The
investments and strategies discussed herein may not be suitable for all investors. The material is not intended to provide, and should not be relied on for,
accounting, legal or tax advice, or investment recommendations. Changes in rates of exchange may have an adverse effect on the value, price or income of
investments.
All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant
to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be
interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request.
International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation
policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other
nations. The Fund's investments in emerging markets could lead to more volatility in the value of the Fund. As mentioned above, the normal risks of investing in
foreign countries are heightened when investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack
of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is
issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is regulated by the Financial Services Authority; in
other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l., Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss
Financial Market Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset
Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management
(Singapore) Limited which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited which is regulated by the Financial
Services Agency, in Australia by JPMorgan Asset Management (Australia) Limited which is regulated by the Australian Securities and Investments Commission and
in the United States by J.P. Morgan Investment Management Inc. which is regulated by the Securities and Exchange Commission. Accordingly this document should
not be circulated or presented to persons other than to professional, institutional or wholesale investors as defined in the relevant local regulations. The value of
investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
270 Park Avenue, New York, NY 10017
© 2012 JPMorgan Chase & Co. | MI to II Institutional_ Focus on emerging market corporate debt_2012
FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY | NOT FOR RETAIL USE OR DISTRIBUTION
jpmorganinstitutional.com