Corporate debt fastest growing part of EM debt universe, says Ashmore’s De Mones
Alexis De Mones, head of Fixed Income at Ashmore, discusses the Emerging Markets corporate bond debt universe and why higher spread and lower duration characteristics in comparison to developed market credit indices offer one of the most compelling opportunities in global fixed income markets today.
A rapidly growing, deepening market
Over the past decade, the Emerging Markets (EM) corporate bond market has changed beyond recognition: it has gone from a small, often overlooked corner of the Emerging Markets debt universe to a fully-fledged asset class. This market has grown in size and breadth as new issuers have tapped it and have issued a growing number of bonds in larger sizes and longer maturities. Over time, we have seen more asset managers and bank trading desks have become involved, helping to deepen liquidity, develop research coverage, and facilitating the participation of more investors into the universe.
Like its sovereign cousin, the EM corporate debt market is divided into hard currency and local currency denominated instruments. Taken together, we estimate that they amount to over $7.5trn in total tradable bonds outstanding. Whilst many investors are more familiar with the USSD denominated part of the market, the local currency denominated part is far larger in absolute size and now benefits from a dedicated global index launched in 2013 by BoA Merrill Lynch. This should generate increasing investor interest in 2014 and beyond.
Attractive relative value and performance in comparison to DM credit assets
Emerging Markets corporate spreads are higher than similarly rated US paper, and the lower the rating the larger the difference tends to be. The spread pick up achievable in high yield is higher than in the investment grade space; investors can pick up around 275 bps by investing in high yield EM corporates compared to high yield US corporates.
Furthermore, since credit rating agencies have always been more conservative with their ratings for EM corporates, this spread pick up actually understates the risk-adjusted difference. In addition, corporate credits tend to be rated at or below their sovereign credit ratings. This ensures that the yield of EM corporate credits includes compensation for the sovereign credit risk, which is not always the case in developed markets, where the sovereign risk is simply assumed away. This has led to higher historical returns than that available from developed corporate credit markets.
Demand and supply dynamics remain favourable
The continued growth and development of the EM corporate debt market will be driven by both supply and demand factors:
• On the supply side: EM corporate issuers are taking advantage of the low all-in yields available to fund growth and expansion plans but also to improve balance sheet flexibility by refinancing older, more expensive debt, terming out liabilities and increasing their cash buffers (Figure 5). 2013 equalled 2012’s record EM corporate debt issuance of around $330bn. During 2013, EM corporates have routinely issued in benchmark sizes of $500m to $1bn and in maturities of 10-years and above. Whilst local currency corporate debt issuance continues to develop, access to the international USD denominated market remains a significant source of long-term funding for EM corporates
• On the demand side: relative spreads, robust fundamentals and the increased depth and breadth of the market are attracting new investors to the asset class. Many investors see EM corporate debt as an extension of their existing global credit allocation and an attractive way to gain exposure to the secular growth story offered by Emerging Markets. A growing number of investors are also coming from Emerging Markets themselves, where pension funds and insurance companies have become more sophisticated and are comfortable investing in corporate credit on a regional or a global basis, in Latin America and Asia in particular. Participation in this market is shared broadly between allocations to ‘blended’ EM debt funds, direct investment in EM corporate securities, and the funding of dedicated EM corporate debt mandates. The relative outperformance of EM corporate bonds vs. other EM bonds in 2013 suggest that investors’ allocation to EM corporate debt is treated as a structural, long term holding in many portfolios. And whilst investors in this asset class are today largely institutional, there is increasing interest from retail investors as well.
Emerging Markets corporate debt provides a very good solution because of the following reasons:
• EM corporate bond yields are very attractive in comparison to most other global fixed income and credit products. The asset class has rarely been as cheap in comparison to US corporate credit since the financial crisis in 2008. US high grade and US high yield did widen a little bit during the ‘Taper tantrum’ in the spring of 2013, but have recouped all their spread widening and more, which is not the case for EM corporate bonds, that have continued to be unloved.
• The losses suffered by fixed income portfolios in 2013 were a stark reminder of the dangers of duration in an interest rate tightening environment. Many investors today are seeking to reduce the average duration of their fixed income portfolios. However, with the US yield curve steepening, the roll down the curve can make reducing duration very costly in terms of running yield. An allocation to a fixed income product with much shorter duration, such as EM corporates, can be a very effective way to reduce duration without bringing the portfolio’s yield to maturity too far below the target yield/return.