Not so long ago, if you had described emerging market (EM) corporate debt as the next big thing, you would have been dubbed a fantasist with little investment knowledge.
This was not without reason. Over a period of about 20 years from the 1980s, a series of crises ripped through the financial systems of South America, Asia and Russia. These events forced emerging market states to tighten their belts, a practice that naturally filtered through to the company level.
At the same time, the regions underwent major political and technological upheaval, which included the dissolution of the Communist bloc and the opening up of previously inaccessible markets such as China.
Yet while these initiatives were generally applauded, investors were less forgiving. There was little faith in the corporate governance structures in these countries following the range of crises. This was the case until the Western debt crisis in 2007, which highlighted just how financially sophisticated emerging markets had quietly become behind the scenes, while exposing severe structural failures in the West.
This sparked a flurry of EM bond fund launches as asset managers looked to exploit the phenomenon. Almost all of these focused on sovereign debt, where hefty state surpluses made the opportunity very visible, with corporate credit seen as a bit too niche.
Over the past five years, these sovereign debt funds have not let investors down and as trust grows, the opportunity in their corporate relatives has become increasingly apparent. In the immediate aftermath of the credit crisis, emerging market companies fought to stand on their feet in the turbulence and five years on, their efforts are starting to be appreciated.
Threadneedle emerging market debt fund manager Zara Kazaryan explains: ‘Emerging market companies learned some painful lessons in 2008-09, and in general currently possess the financial flexibility to meet forthcoming debt maturities, continue to diversify their business away from significant geographical concentration, and hedge the existing debt stock.’
Meanwhile, Aberdeen Asset Management highlights how the credit crisis demonstrated the resilience of emerging market companies. ‘2009 was the year of particularly high default rates. Even then, the default rate for high-yield EM corporate bonds was 6.1%, of which approximately three-quarters came from the Kazakhstan bank sector,’ Aberdeen says.
‘This compares to 9.5% for global corporate bonds and 11.2% for US high-yield corporate bonds. Outside of the Kazakhstan banking sector, 2009 default rates were very low in emerging market corporate bonds.’
This increased market sophistication is illustrated by the rise of the Emerging Market Corporate Bond index, which hit a capitalisation of $469 billion (£292 billion) at the end of September, surpassing its $463 billion sovereign debt equivalent for the first time.
On top of this, JP Morgan expects corporate debt issuance to reach $255 billion this year, dwarfing the $80 billion for sovereigns.
Quality matches sector growth
Marge Karner, senior emerging market debt (EMD) portfolio manager at HSBC Global Asset Management, expects corporate credit to take the EMD limelight within five years. She also emphasises the quality of the debt, pointing out the corporate universe is more than 70% investment grade, with 80% of new issues expected to be of this standard in 2012.
‘High credit quality is supported by the strong balance sheets of these emerging market companies,’ Karner says. ‘Since current global growth is mainly driven by emerging market countries, many EM corporates also enjoy strong organic growth, which further strengthens their balance sheets and keeps average leverage low despite increased issuance.
‘Additionally, EM corporates still enjoy favourable cost structures compared with developed markets (DM) and are further sustained by more attractive labour force demographics. The macroeconomic environments of many emerging market countries have transformed over the past decade and now offer a stable operating base to private companies.
‘In many ways, the comparison of emerging market corporates to developed market peers mirrors the comparison of emerging sovereigns to developed sovereigns.’
Standalone asset class
Aberdeen, which has built its reputation on EM equities, has identified the compelling opportunity in corporate credit. The firm believes the sector has come into its own as a standalone asset class and highlights several reasons why it has become a viable alternative for fixed income investors.
These include diversity, a wider investment base and low default rates, along with the significant increase in the size of the market and good liquidity supported by greater issuance.
‘The asset class was previously only viewed in piecemeal fashion by regional investors or as a specialist source of returns for investors seeking "risky" alpha,’ Aberdeen EMD portfolio manager Esther Chan says.
‘Now, dedicated financial infrastructure such as investable market indices, dedicated research and rapid growth in market capitalisation from increasing issuance has brought this burgeoning asset class into
She adds: ‘On top of this, the fundamental case for emerging market companies is compelling. Emerging economies are healthier and less leveraged than developed countries, as are the companies within them.
‘Companies and banks that have emerged as survivors of the recent financial crisis are entities that now have experience in managing operations and understand the vagaries of capital markets and management – lessons that will hold them in good stead in the years ahead. Additionally, default rates have dropped significantly since 2010.’
The potential for corporates to offer more diversity than sovereigns is outlined by Kazaryan. ‘While the emerging market hard currency sovereign debt asset class is more mature than its emerging market corporate debt counterpart, it is also limited in terms of its size and growth potential. There is clearly a ceiling on the number of countries in the emerging market universe, yet the potential number of quality corporates coming to the market is vast,’ she says.
‘We believe that the potential diversity and the size of the corporate debt asset class are significantly larger than that of sovereign debt.’
Suited to weak macro outlook
EMD pioneer Investec also believes now is the time for corporate credit to flourish, especially as it is becoming increasingly easy to do business across the region.
Investec portfolio manager Victoria Harling sees the asset class as perfectly placed to perform well in the difficult macro environment. ‘In the current environment of weaker growth and cautious corporate strategy, corporate bonds are positioned to perform well – a significant part of the value in emerging market corporate bonds lies in their priority claim on cashflows and assets,’ she says. ‘In an environment of weak growth, companies are focusing on strong cashflows and deleveraging, which favours bondholders.’
However, some are concerned about the quick rise in the asset class. PSigma Investment Management’s chief investment officer Tom Becket is among those who believe sovereign debt remains a safer bet. ‘We have recently seeded the AXA Short Duration Emerging Market Bond fund, which predominantly focuses on government bonds,’ Becket says.
‘We sold an emerging market corporate credit fund to pay for this allocation, as we had become concerned over an asset class that had become very overbought, due to the intense hunt for yield, and where illiquidity could easily be an issue in challenging markets or were sentiment to change. With the yields available from emerging market corporates falling so far, we no longer felt that you were being compensated with sufficient yield to justify the risk.’
Harling, though, continues to see plenty of value in the asset class. ‘The dividend yield of emerging market equities (hedging out exchange rate risk) is actually 0% compared with the 6.2% coupon on emerging market credit. This suggests emerging market corporate debt currently offers more value than emerging market equity, given the greater security of cashflows to bondholders,’ she adds.
Meanwhile, Chan points out there is potential to exploit valuation anomalies as ratings agencies continue to give an EM risk premium to companies operating in the region.
‘Non-investment grade corporate bonds are typically issued by companies operating in countries widely regarded as safer, such as Brazil, Mexico, Russia and Indonesia, where we are very confident of the macroeconomic fundamentals,’ she says.
HBSC head of global emerging market debt Guillermo Ossés also sees value opportunities. ‘Many emerging market corporates currently offer favourable valuations versus their global peers.
‘On average, for similar credit quality, emerging market corporates offer higher yields and more attractive spread levels over their US peers while having lower leverage and sounder balance sheets,’ he says.
‘For example, year to date 2012 (to mid-October) BBB-rated emerging market corporates have an average spread level of 331 basis points compared with 237bps for US BBB-rated corporates, with almost half the average net leverage, 1.06 versus 1.92 respectively.’
While Ossés accepts the challenges driven by market dynamics and investor perception remain, along with potential liquidity problems in a market downturn, he believes corporate debt will reward investors over the longer term.
‘We expect these issues to improve over time as the asset class develops, and we believe the positive benefits of investing in EMD corporates far outweigh these challenges.’