For investors looking for low volatility yield, emerging market corporates can be an attractive place to invest. The asset class is 60% investment grade (IG), with low volatility and low drawdowns (compared to other credit asset classes). Most importantly, with over 1,200 bonds from 52 countries across 12 sectors in the JPM CEMBI index, the asset class offers investors a wide range of opportunities. For active managers like us, there are many great alpha opportunities. In addition to capturing positive market performance, our investment approach also seeks to protect investors on the downside.
EM corporate credit is more than just ‘sovereign-plus’
Emerging market corporate credit grew out of the sovereign bond market and has expanded significantly in the past decade. Indeed, the outstanding notional value of EM corporate debt is now more than double that of sovereign debt in hard currency terms*.
In its infancy, the asset class was centred around its sovereign parent. Many EM companies started off with some level of state sponsorship, so a natural form of analysis was to evaluate the issuer as an extension of its sovereign parent. As state-owned enterprises were privatised or spun-off, EM companies sought to diversify their funding base and the asset class started to grow. Almost two decades later, the EM corporate debt asset class is not just larger but also more diverse than EM sovereign debt.
It is also an investor-friendly asset class. For example, more than 70% of issuers adhere to either International Financial Reporting Standards (IFRS) or US GAAP**, making financial statement analysis more straight-forward, and making company comparisons across geographies easier to do. In addition, a number of countries (eg, Mexico, Brazil, China) have accounting rules that are very similar to the IFRS/US GAAP, accounting for close to 15% of additional NAV. Finally, more than 85% of EM corporate issuers are publicly listed, which adds a layer of transparency and corporate governance.*Hard currency = external debt issued mostly in US. **Generally Accepted Accounting Principles developed by the Federal Accounting Standards Advisory Board of the United States.The asset class is very diverse, and can offer alpha opportunities
EM economies have grown in strength and now represent over 57% of global gross domestic product, on a purchasing power parity basis (IMF’s October 2016 World Economic Outlook). While in the past, emerging markets were associated exclusively with issuers reliant on natural resources, such as oil, iron ore or agricultural products, the market has changed significantly. As countries grew, industries were also strengthened, leading to a wider and deeper issuer base. This, as noted above, has naturally coincided with the steady growth in EM bond markets, resulting in a diverse set of participants and issuers across sectors from financials and utilities to transport and industrials.
The list of example companies ranges from systemically important state-owned enterprises, such as Petrobras in Brazil or China State Grid, to multi-nationals such as JBS, a Brazilian meat processor (the largest in the world) or Hyundai Motor, the Korean auto manufacturer. There are companies whose businesses are focused almost entirely on exports, such as Brazil’s Fibria (pulp and paper), while others have a domestic focus, such as Alibaba, the Chinese e-commerce company. Issuance can also range from companies with foreign currency exposure, to those without; some companies can even hedge their currency risk.
For investors wanting to express a view, EM corporates offer a large, diverse set of issuers with different macro, country, sector, duration, and credit drivers. As a result, there are many opportunities to generate alpha. Do opportunities in EM corporates warrant a strategic allocation?
The EM corporate debt asset class is growing, not shrinking. Debt from EM corporates has outpaced EM sovereigns, and now represents 67% of total EM debt compared with 47% ten years ago. Long-term fundamental improvements in EM economies have also improved the credit quality of the asset class. In 2016, 64% of the corporate debt stock was investment grade compared with less than 40% back in 2000.
Today, there are many developed market companies that have more underlying exposure to emerging markets than some EM companies; often, when you buy corporate bonds from emerging markets, you are buying the debt of very solid companies — they are just based in the ‘wrong’ zip/postal code. Many of these companies are also assuming a more significant role in global corporate consolidation, often acquiring developed market competitors.
EM bonds form an investment grade asset class that offers lower volatility and higher yields than comparable developed market bonds, but with additional diversification benefits not readily available in the developed world. EM corporate bonds have traditionally offered relatively high returns, but have low correlation to certain other bond markets such as developed market government bonds. Finally, as the chart in Figure 1 illustrates, the yield on EM corporate bonds continues to be among the highest currently available in fixed income markets. For these reasons, we think the asset class merits a strategic asset allocation.Figure 1: EM credit offers high income, as well as diversification benefitsSource: Thomson Reuters Datastream, JP Morgan, Janus Henderson Investors, yields as at 31 July 2017Note: Euro Corp IG: JP Morgan Maggie, US Corp IG: JP Morgan Juli ex EM, EM Corp IG: JP Morgan CEMBI Broad Diversified (IG), Euro Corp HY: JP Morgan Euro HY, EM Corp: JP Morgan CEMBI Broad Diversified, US Corp HY: JP Morgan HY. 5Y UST: US generic 5Y Treasury, 5Y Bund: German generic 5Y bund.The near-term outlook is benign
The broader EM fixed income market strength has been underpinned by sustained, recurring inflows into the asset class. We believe that these inflows are from investors in search of low volatility yield. Consistent inflows of US$1-2 billion per week since June 2016 (save a few weeks during and after the US presidential election) would imply that inflows are strategic, and likely to be broad-based; possible sources are from Asian life insurance companies, sovereign wealth funds, and pension funds. With a nascent exchange-traded fund (ETF) market for EM corporates, we believe that inflows into funds are likely to stay strong, extending the current positive technical environment.
The chart in Figure 2 shows the strong recent relationship between inflows and the JP Morgan CEMBI yield. Yields have reflected flows fairly well. We think the market has room to continue to perform. Figure 2: capital inflows into EM driving yields lowerSource: BoA Merrill Lynch, JP Morgan, Janus Henderson Investors, as at 26 July 2017Note: Inflows into EM corporate bonds and yield to worst on the JP Morgan CEMBI index
In addition to strong technicals, the overall macro backdrop has been benign. Unprecedented central bank intervention around the world has generally benefited markets. It has created low volatility, which has been a boon to investors across many asset classes. The lack of meaningful systemic issues has also extended the current bull market rally into its ninth year. But along with market stability, we have also seen low rates, low inflation, and rather unsurprisingly, low growth. These factors have persisted in the US and across most countries in Europe, along with a handful of emerging countries such as Brazil. But there have also been countries that have benefited from this, such as China and Chile, two exporters with strong fiscal accounts.Active managers can outperform the market
We believe the best investment approach is a holistic one, with consideration of both macro and micro factors. We manage our portfolio in an 'index aware' manner, rather than aiming to replicate the index. Crucially, we take an active role in managing the downside risk and are not bound to any particular country, sector, duration or position weights. We view each investment as a sum of its parts, paying attention to several factors concurrently. We believe this holistic approach provides a well-rounded, thorough view on the investment.
As the EM corporate asset class was borne out of a sovereign strategy; many peers still primarily rely on country views to anchor their investment decisions. Our strategy is instead underpinned by credit-intensive, fundamental company analysis. We then use macro inputs to help us with the timing of our investments, paying attention to market liquidity and technicals as well. In our experience, country risk alone is inadequate in assessing EM corporates, which is why we invest in companies, rather than countries.
The growth of EM corporate credit has been propelled by privatisation, structural growth, and international merger and acquisition (M&A) activity. In addition, financial disintermediation has and will continue to increase the breadth of issuers across countries and sectors, and across the credit curve. The investment opportunities are both numerous and diverse. Also, with EM economies growing stronger, credit ratings have improved and investor sentiment has turned more positive around this fast growing asset class.
We believe the Janus Henderson EM credit approach is best suited to capture opportunities in this dynamic market. Our performance reflects our unique investment philosophy, with top tier returns and low volatility (see Figure 3 below).Figure 3: EM corporate bond funds: peer group returns since November 2014
Source: Janus Henderson Investors, Morningstar, as at 31 July 2017Note: Peer group derived from the official Morningstar peer group by adjusting for specialist funds (High Yield/High Grade/Distress Debt); cumulative returns since strategy inception on 5 November 2014; performance is for the A share class, net of fees; benchmark is the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Diversified. Past performance is not a guide to future performance.