Many investors in emerging market debt (EMD) choose not to own (or have very limited exposure to) EM corporate bonds, even though they have provided the best risk-adjusted returns historically.1 Therefore we are often advocates of the long-term benefits that exposure to EM corporate bonds can provide for a diversified portfolio.
So, in terms of the current environment, is now a good time to consider increasing your EM corporate bond allocation? While you might find arguments for both sides from investment banks and investment managers, to effectively answer this question, we think that it makes sense to go back to basics, and to think about simple return prospects versus actual credit risk, as well as considering market technicals.
Looking at simple metrics such as yield to maturity or yield to worst, today, the JPM CEMBI index (one of the primary EM corporate bond indices) offers a yield to worst of more than 7%. In the 20 years since the start of the index, we’ve seen higher values only in the midst of the 2008 global financial crisis and in the early 2000s, when developed market government bond yields were much higher. Nevertheless, indices do not tell the full story, and we believe taking an active approach can still allow us to identify many compelling opportunities to build an allocation with higher yield potential.
Furthermore, it’s worth recognising that higher yields (or lower prices) should not be seen only as a return engine, but also as a defence mechanism. For example, if there is a material widening in spreads in the coming months (e.g. around 100bps), it is still possible for an investor to reach positive overall returns, thanks to a higher starting yield. In other words, higher yields today offer a more asymmetric risk profile tomorrow, with few not so bad scenarios and many relatively good ones.
…but look beyond yield, too
On the other hand, yields are not everything when investing in fixed income markets – credit spreads must be considered as well. From a historical standpoint, while we’ve seen wider EM corporate bond spreads during times of crisis or broad EM weakness, interestingly this is the first time this has happened while oil prices are relatively high, meaning there are some unique aspects to the current environment.
As of 22.07.22, source: Bloomberg
Oil producers, as well as other issuers that benefit from higher oil prices, are an important segment of the universe. Furthermore, while spreads might not currently be pricing in a global recession, sentiment has been relatively weak lately. EM corporate bond high yield issuers have underperformed most in recent weeks and are now offering historically compelling spreads of 220bps (as of 07.22.22) versus US high yield bonds, compared to a historical average of around 139bps.
As of 22.07.22, source: Bloomberg
Strongest fundamentals in a decade
Against this backdrop, somewhat counterintuitively, we believe fundamentals for EM corporates are now in better shape than we’ve seen over the past 10 years, with net leverage at the lowest levels, and interest coverage ratios at the highest. When comparing EM corporate bonds with their developed market counterparts, emerging markets issuers are also in a much stronger position in terms of the above-mentioned metrics.
In terms of technicals, EMD mutual funds have posted outflows of $56bn2 so far in 2022. Portfolio managers have retained material cash positions as a precautionary measure, though it is possible that this very poor flow picture could reverse, which would be supportive for the asset class. Meanwhile, to date, 2022 has generally been weak for primary markets, with a negative net financing of -$108bn.3 The schedule of maturities remaining for 2022 and 2023 looks manageable, but higher refinancing costs in the primary market could clearly put pressure on default rates.
Constructive over the short and longer term
To conclude, while in absolute terms spreads have been wider historically, we believe that could be for good reasons given some of the unique features in the current environment, and strong fundamentals support the credit standing of EM corporates. Positive and negative catalysts might come instead from technicals, though overall, we believe compelling all-in yields generate an attractive entry point. As such, we are constructive on the future prospects for EM corporate debt not only over the longer term, but also over a shorter time horizon.
While bonds with no credit rating, including high yield, may offer a higher income, the interest paid on them and their capital value is at greater risk of not being repaid, particularly during period of changing market conditions. In difficult market conditions, reduced liquidity in bond markets may make it harder to sell assets at the quoted price. In extreme market conditions, certain assets may become hard to sell in a timely manner or at a fair price. Investing in emerging markets carries greater risk than investment in more traditional western markets.
1Source: JPM EMBIG Diversified for EM HC Sovereign Debt, JPM CEMBI Broad Diversified for EM Corporate Debt, JPM GBI EM for EM LC debt, as of 30.06.22.
2Source: J.P. Morgan, EPFR Global, Bloomberg Finance L.P, as of 22.07.22
3Source: JP Morgan, 22.07.22
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