- EM credit grew out of the sovereign bond market and has expanded significantly in the past decade.
- Rapid economic growth and the adoption of more conventional bond structures and reporting methods have seen the asset class flourish.
- Investors are increasingly viewing the asset class as a valuable source of returns and portfolio diversification.
Emerging market (EM) corporate bonds offer a relatively high yield often for investment grade-style characteristics. Within the JPMorgan Corporate Emerging Markets Bond Index (CEMBI) there are more than 1,400 bonds from 644 issuers in 51 countries across 12 sectors (as of June 30, 2018) so the asset class offers a wide range of alpha opportunities for active managers. Investors are increasingly viewing the asset class as a valuable source of returns and portfolio diversification.
A Growing Market
EM credit grew out of the sovereign bond market and has expanded significantly in the past decade. Rapid economic growth and the adoption of more conventional bond structures and reporting methods have seen the asset class flourish. Exhibit 1 demonstrates how the EM corporate bond market has overtaken the developed market high yield market in size within the last few years.
Exhibit 1: Corporate Debt Stock by Asset Class, US$B
|EM external corporates||860||1,378||1,692||2,075||2,140||15%|
|DM IG corporates||3,995||4,414||5,337||5,678||6,243||7%|
|DM HY corporates||1,147||1,379||1,560||1,498||1,458||4%|
Source: JPMorgan CEMBI Monitor, June 2018, DM = developed markets, IG = investment grade, HY= high yield, CAGR = compound annual growth rate between December 31, 2011, and June 30, 2018.
The emerging market corporate bond sector comprises three areas:
- Corporate bonds denominated in hard currency (external): These bonds are denominated in external hard currency, primarily U.S. dollars, rather than the domestic local currency. As the largest and most investable component of the emerging market bond sector, this is the focus for most emerging market corporate bond funds.
- Quasi-sovereign bonds: These are corporate bonds in which the government owns a partial stake in the issuing company but from a legal perspective do not carry full legal sovereign status, so the bondholder’s legal claim on debt repayments only extends as far as the issuing company. This is also an area in which EM corporate bond funds often invest: it represents 27% of the CEMBI as of September 30, 2018.
- Corporate bonds denominated in local currency: These bonds reflect the local currency of the issuer, so tend to be viewed as riskier, although the risk premium can present additional return opportunities.
Diverse Opportunity Set
In the past, EM credit was associated exclusively with issuers reliant on natural resources, but as economies have grown and industries have developed there is a much wider and deeper issuer base that includes everything from financials and utilities to transport and technology. The types of companies range from systemically important state-owned enterprises to multinationals and domestically focused businesses. In turn, they have varying degrees of reliance on domestic or international markets.
Today, there exist developed market companies with more underlying exposure to emerging markets and EM companies with more exposure to developed markets. Often, EM corporate bonds can represent very solid companies – they are just based in the “wrong” ZIP/postal code. Increasingly, EM companies are assuming a more significant role in corporate consolidation, often acquiring developed market competitors.
The political background of EM is typically more fluid than developed markets. Investors are required to pay close attention to election schedules and outcomes, which can be a catalyst for both challenges and opportunities as fiscal landscapes are reshaped. Environmental, social and governance factors have key roles to play in helping to differentiate between corporate borrowers.
For investors wanting to express a view, EM corporates offer a large, diverse set of issuers with different macro, country, sector, duration (interest rate sensitivity) and credit drivers.
Strong Long-Term Total Return Potential ...
EM corporate bonds have historically offered attractive total returns. Exhibit 2 shows the total return of EM corporate bonds (as represented by the JPMorgan CEMBI Broad Diversified Index) against a number of U.S.-denominated asset classes. Despite being primarily investment grade, EM corporate bonds have generated a performance similar to risk assets such as equities and high yield, but with visibly less volatility.
Exhibit 2: Total Return of Asset Classes since start of CEMBI Data on December 2001, Index Rebased
Source: Thomson Reuters Datastream, JPMorgan, December 31, 2001, to June 30, 2018. U.S. HY = ICE BofAML US High Yield Index, EM corp bond = JPMorgan Corporate Emerging Market Bond Index Broad Diversified, U.S. Investment Grade Corp = ICE BofAML US Corporate Index. All indices in USD terms and rebased to 100 on December 31, 2001.
… And Competitive Yields
Income is the leading component of total return in many asset classes over the long term, so the relatively high coupons (income paid out to investors on a periodic basis) on EM corporate bonds have helped to contribute to the strong returns from the asset class. As Exhibit 3 demonstrates, the yield on EM corporate bonds continues to be among the highest available within fixed income markets. What is more, EM corporate bonds typically offer a favorable credit profile. Exhibit 3 shows that EM corporate high yield (HY) on August 31, 2018, was offering a lower duration, higher spread, higher yield, and two notches better credit rating than the U.S. equivalent. Taken in aggregate, EM corporate bonds (represented by the light red column) offer an investment grade credit rating but a yield more akin to high yield bonds.
Exhibit 3: Yield to Maturity
Source: Thomson Reuters Datastream, JPMorgan. Janus Henderson Investors, BAML, as of August 31, 2018. Note: Euro Corp IG:JPMorgan Aggregate Index Europe, U.S. Corp IG: JPMorgan US Liquid Index ex Emerging Markets, EM Corp IG: JPMorgan Corporate Emerging Market Bond Index Broad Diversified Investment Grade, EM Corp HY: JPMorgan Corporate Emerging Market Bond Index Broad Diversified High Yield, Euro HY: JPMorgan Euro High Yield Index, EM corps: JPMorgan Corporate Emerging Market Bond Index Broad Diversified, U.S. HY: JPMorgan High Yield Bond Index US, U.S. Generic 5-year Treasury and German Generic 5-year Bund.
Improving Credit Quality
As EM countries and companies experience fundamental improvements driven by growth and fiscal discipline, ratings agencies have responded with upgrades. The profile of the EM corporate debt market has been improving over time: in mid-2018, some 67% of the emerging market corporate debt stock was investment grade compared with less than 40% at the start of 2000.*
*Source: ICE BofAML EM Corporate Indices, July 31, 2018.
As the EM bond market has grown, bond structures have gradually converged toward those of developed market corporate bonds. Like their developed market counterparts, EM corporate bonds are typically:
- Plain vanilla, with fixed rate coupons
- Protected by covenants (rules governing the issuer, that are attached to the bonds)
- Denominated in hard currencies
- Issued under New York or English law
Balance sheet strength
Although EM debt is typically synonymous with increased risk, EM companies on aggregate tend to be more financially conservative than their developed market counterparts, with higher cash levels and lower leverage (debt to equity) ratios.
Capturing Emerging Market Dynamism
Emerging market economies have grown in strength and now represent more than 59% of global gross domestic product, on a purchasing power basis (IMF World Economic Outlook, April 2018). Moreover, emerging market countries tend to exhibit idiosyncratic features, so while one country’s growth may be slowing, another may be growing rapidly. For example, growth in Thailand slowed sharply in 2013 and 2014, and subsequently recovered, yet the Philippines grew at a consistent 6 to 7% between 2013 and 2018. Exhibit 4 illustrates that emerging markets, in aggregate, continue to outpace developed markets, providing valuable momentum to domestic corporate earnings.
Exhibit 4: Real GDP Growth, Year-On-Year %
Source: IMF World Economic Outlook, April 2018.
EM credit has the potential to boost the risk-adjusted returns of a diversified portfolio. For example, EM corporate bonds have historically offered relatively high returns but with low correlation to other bond markets, particularly developed market government bonds.
Exhibit 5 illustrates the effect of adding EM corporate bond exposure in 10% increments to a global government bond portfolio. It shows that an increase in exposure initially leads to an increase in return and a decrease in volatility.
Exhibit 5: Efficient Frontier
Source: Bloomberg, JPMorgan Corporate Emerging Market Bond Index Broad Diversified, ICE BofAML Global Government Index, December 31, 2001, to June 30, 2018, using monthly returns data. Volatility represented by standard deviation.
Risks Associated with EM
It is important to recognize that there are additional risks attached to investing in emerging markets.
- Political risk: Emerging markets tend to have more volatile political backdrops, often because democratic foundations are less well-established. Companies domiciled in or operating in emerging markets may also face more government intervention or be impacted by adverse political decisions, such as capital controls.
- Currency risk: Like non-EM issuers, EM corporate bond issuers can be exposed to a currency mismatch between their earnings stream and their debt obligations. In addition, earnings volatility can arise for companies with export sales and/or a multinational presence.
- Legal standards: Standards of corporate governance and accounting practices of EM companies are still converging toward established developed market conventions. Different countries have different conventions, highlighting the importance of rigorous due diligence when assessing an EM company’s fundamentals and its bond structure.
By the same token, these risks may translate into higher yields for EM corporate bonds than developed market bonds, providing an opportunity for portfolio managers to capture this additional upside through good asset allocation and security selection.