In the last decade, the emerging market (EM) corporate bond market has been cheaper than today on just three occasions: 2011 (oil shock), 2015 (the start of the last US rate hiking cycle) and 2020 (pandemic). Today’s position has been driven by Russia’s invasion of Ukraine and weakness in China. At the same time, EM corporate net leverage is close to the lowest levels we have ever seen. The market looks oversold, considering that higher global inflation would be expected to benefit many emerging market corporates who are producers and exporters of commodities. This has created an excellent opportunity for fund managers who care deeply about risk mitigation and keeping the portfolio diversified at all times.
Today the EM credit index yields over 6%. When we consider the strong relationship between yield and realized performance in the following 3 to 5 years, today’s yields look interesting:
CEMBI Diversified Broad Index Spread – Last 10 years
EM Credit is underappreciated
Is this a rare opportunity to add to an under owned asset class? Many investors only buy sovereign debt. Over the long term, corporate debt has delivered better risk-adjusted returns with more liquidity and more sector diversification. It’s under owned by passive investors, so is less prone to panic selling in a crisis. Relative to developed markets, it has much lower leverage for the same credit quality, and is cheaper than it has been for over five years. The quality of the asset class has improved in recent years: as the recent crisis has shown, EM credit has not suffered systemic contagion from localised events.
Is the bad news now in the price, or does it get worse from here? Impossible to be certain, but we are starting to sniff some of the best opportunities to buy in a long time.
How much is priced in?
Starting with the distressing humanitarian crisis in Ukraine: Russian assets have been written down to next to nothing, and Russia has been excluded from EM indices. Regional contagion has so far been fairly limited, and further escalation is not our base case.
We were underweight Russia before the invasion and managed the situation using hedges such as short rouble, and long commodities.
We wrote about how the situation in China real estate is unlikely to be resolved soon, but with the market down by nearly two thirds since May1, and many names trading under 50% of par, there is less room for the market to worsen. We’ve been underweight China real estate for some time.
The main headwind to EM debt today is the macro environment. The market is starting to price higher global recession risk thanks to the situation in Ukraine, and investors are worried that inflation could lessen the ability of central banks to intervene compared with other recent crises.
It’s extremely difficult to call a bottom in a sell-off. The picture remains very unclear particularly with regards to inflation, but this is what the best buying opportunities always feel like.
Opportunities
A lot of EM countries benefit from higher commodity prices, and many have been dealing with higher inflation for a long time, and are much farther advanced in tightening policy than in the US or Europe. Credit fundamentals are improving in EM, especially relative to developed markets. In LatAm, some of our favourite energy names can be bought at low cash prices. We’ve seen stable, asset-backed, utility companies with dollar cash flows sell off to more attractive levels. We’re also seeing great opportunities in Indian renewables, Indonesian energy companies, and more.
We are finding very select opportunities in local FX in places like Brazil, which have sold off aggressively, benefit from higher commodity prices and where policy has already been tightened. History tells us that when the backdrop improves, the market moves extremely quickly. Therefore, investors have a rare chance to add to emerging market assets.
1Source: Bloomberg: Markit iBoxx USD China Real Estate High Yield Index down 64% since peak in May 2020
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