The Evolution, Resilience, and Attractiveness of Emerging Markets Corporate Bonds

Jean-Dominique Butikofer

Jean-Dominique Butikofer, CFA

Head of Emerging Markets

Yalcin Tarkocin

Yalcin Tarkocin, CFA

Analyst

EM Corporates could be a valuable source of total return, carry, and diversification.

Emerging Markets (EM) Corporate Universe and Returns

Since 2001, the Emerging Markets Corporate Bond Market issued in USD (or “CEMBI” market – per JP Morgan CEMBI Broad Index, the largest benchmark in the space) has grown into a nearly $1.25 trillion standalone asset class (Figure 1) worthy of consideration for investors looking to diversify their EM and broad credit exposures.

In the two decades since its official inception, the CEMBI market has grown larger than the $750 billion EM Hard Currency Market (or “EMBI” market – per JP Morgan EMBI Global Diversified Index) and is quickly gaining on the more mature $1.6bn U.S. High Yield Corporate Bond Index Market (Bloomberg Barclays index). As such, EM Corporates could be a valuable source of total return, carry, and diversification when blended with an EM Hard Currency Sovereign strategy. Blending EM Corporates with Hard Currency Sovereigns and Quasi-Sovereigns expands an investor’s EM “credit” toolkit and can improve long-term risk-return metrics. Thus, this strategy offers relative stability, as opposed to adding local currency, which has historically been a much higher source of volatility without the benefit of strong return.

Figure 1. EM Corporate Debt (USD): A Growing Asset Class

Source: JP Morgan. As of 12/31/2020. Indices do not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.

But even beyond the EM environment, EM Corporates have evolved into an asset class increasingly capable of offering competitive total and risk-adjusted returns with lower volatility over the long term (Figure 2). With over 1,750 issues from over 720 entities across 12 industries and 58 countries, the EM corporate debt market can serve as a well-diversified, risk-adjusted complement in a fixed income portfolio. In addition, investors can select bonds across the full rating spectrum on the EM corporate debt market.

Figure 2. EM Corporate Debt: Attractive Risk-Adjusted Returns

Source: Voya Investment Management, Bloomberg. Data based on monthly returns from January 2010 – December 2021. CEMBI – JPM CEMBI Broad, EMBI – JPM EMBI Global Diversified, EM Equity – MSCI EM Equity Index, US HY & US IG – Bloomberg Barclays Indices. Indices do not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.

Evolution, Expansion and Growth

In its 19-year life span, the CEMBI Broad Diversified index, the most widely followed EM corporate index by investors, has evolved and expanded across countries and regions, industries, credit qualities, and maturity profiles, offering one of the most diverse asset classes available to investors. The universe now consists of 58 countries, up from 13 in 2001, with China and Russia as two of the top five countries that were not represented at inception. Much of the growth in regional diversification has come from Middle Eastern and African issuers (Figure 3), which now account now for 24% of the index versus less than 3% in 2001.

Meanwhile, growth in the number of regions and countries has led to a more diverse set of industries, with 12 now represented, allowing investors to capture global market themes and sector trends. Many EM countries have matured into more consumption- and services-driven economies, reducing cyclical risks and dependency on exports or commodities, and making the asset class more attractive as a long-term allocation. While Oil & Gas and Metals & Mining are still well represented, highlighting the abundant natural resources across many emerging economies, Financials are now the largest industry represented in the market. That said, Financials are beginning to decline as the market continues to evolve, becoming less dependent on banks and commodity prices. Further, once consisting of over 80% investment grade issues (a higher percentage than the sovereign universe), the Index now includes issues with an average rating of Baa3/BBB-. This shift signals increasing investor confidence as the market has allowed more below-investment grade corporations to issue debt. From a maturity standpoint, the CEMBI market offers investors the ability to allocate across the credit curve. Over a third of issuances are longer than seven years, highlighting investor confidence in the sustainability of issuers. In addition, not all issuers are unrecognizable; CEMBI consists of many household names such as Lenovo, Alibaba, Aramco, Petrobras, BBVA Mexico, Gazprom, Coca Cola Bottlers, and Teva Pharmaceuticals.

Figure 3. Emerging Market Corporate Bonds Have Matured

Figure 3. Emerging Market Corporate Bonds Have Matured

Figure 3. Emerging Market Corporate Bonds Have Matured

Source: JP Morgan. As of 12/31/2020 Indices do not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.

What to Consider: Attractiveness of CEMBI vs. EMBI, US High Yield, and EM Equity

Four key risks should be considered when allocating to emerging markets debt: country, credit, duration, and currency. As noted above, EM Corporates offer an attractive risk-return profile compared to other emerging market and credit asset classes, but certain differences can help investors decide where and how to allocate to EM Corporate debt.

Regional Differences

The EM Corporate market skews towards Asia, which makes up 40% of the CEMBI Broad Div. index versus 18% of EMBI index (Figure 4). On the other hand, EM Sovereigns have been more concentrated in Latin America and Europe. The historical gap in Middle East representation on CEMBI and EMBI disappeared after sovereign and quasi-sovereign issuers from Saudi Arabia, Qatar, United Arab Emirates, Bahrain and Kuwait became eligible for the EMBIG in January 2019. In addition, not all sovereigns (e.g., China, India) issue USD based debt. Investors can still get exposure to those countries through corporate bonds.

Figure 4: CEMBI versus EMBI Regional Composition

Source: JP Morgan. As of 12/31/2020 Indices do not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.
 

Risk (Default & Recovery Rates)

EM Corporates have proven resilient during recent financial crises. Contrary to common perception, EM Corporates had much lower default rates than US high yield (HY) bonds during both the global financial crisis of 2008 and uncertainty created by COVID-19, and lower oil prices in 2020 (Figure 5). In 2020, CEMBI HY had a much lower default rate of 2.7% versus a US HY default rate of 6.8%. Similarly, in 2021 JP Morgan forecasts a lower default rate of 2.2% for CEMBI HY versus 3.5% for US HY. Most CEMBI corporates are national champions with easy access to local and foreign markets capital. Further, national oil companies (NOCs) dominate the oil and gas sector in emerging markets. NOCs are significant contributors to local economies and government budgets, which increases the likelihood of sovereign support during times of distress. This characteristic also helps the EM oil and gas sector handle liquidity crunches when oil prices are low.

In addition, several EM corporates have stronger credit fundamentals (lower leverage and higher profitability) than implied by their credit ratings because their ratings are capped as a result of lower sovereign ratings (e.g., Brazil and Turkey).

Figure 5. Default Rates (EM HY versus US HY).

Source: JP Morgan. As of 12/31/2020

EM Corporates also have higher recovery rates versus advanced market corporates (Figure 6). The average recovery rate for senior unsecured bonds in EM (40%) is slightly higher than in developed markets (36%). The higher recovery rates help investors reduce their losses during default events.

Figure 6: Recovery Rates (EM versus DM)

Source: Moody’s. As of 12/31/2020
 

Rating Differences

The EM Corporate bond market maintains a higher average rating quality at BBB- than sovereigns at BB+ due to a higher proportion of Asian investment grade bonds and lower proportion of African high yield bonds (Figure 7). In addition, EM Corporate indices have issuers from a variety of ratings under each country. Sovereign funds could use these indices to find corporates with attractive yields across different ratings and sectors. EM Corporate indices also contains quasis, entities which are partially government-owned. These corporates (e.g., Petrobras, Israel Electric, OCP) could provide an attractive spread versus their sovereign.

Figure 7: Key Emerging Market Debt Index characteristics

Source: JPM. As of 12/31/2020

 

Duration Risk

EM Corporates exhibit less interest-rate sensitivity with a duration of 4.7 years. Their duration is significantly shorter than EM Sovereigns (8.3 years) and only modestly longer than U.S. high yield corporates (3.6 years).

Currency Risk

Finally, the EM Corporate market consists only of U.S. dollar-denominated debt and thus does not exhibit the currency volatility experienced when allocating to local sovereign markets. However, fluctuations in an EM Corporate issuer’s base currency can affect that issuer’s ability to pay back their dollar-denominated debt, particularly in domestically oriented companies like telecommunications and consumer goods. Investors could mitigate foreign exchange (FX) risk by investing in exporters (e.g., pulp and paper, gold producers), which benefit from currency depreciation. In deciding upon sectors in which to invest, active managers consider whether companies are domestic- or export-oriented. Some corporates hedge their FX risk exposure through currency swaps or by keeping cash in hard currencies.

Capital Structure Considerations

In addition to having seniority over equity in the capital structure, EM Corporate bonds have provided higher total and risk-adjusted returns relative to EM Equities over the last 10 years.

EM Corporate Responsiveness in 2020

As highlighted previously, EM Corporates have been resilient and returned positive returns of 7.4% in the tough year of 2020. EM Corporate default rates have also been moderate and much lower than U.S. HY default rates. EM Corporates had record issuance of $497 billion in 2020, which proves their ability to access external capital markets during times of distress. Companies have used primary markets to increase their liquidity position and extend their maturity profile. Net leverage for EM Corporate investment grade (IG) increased from 1.4x in 2019 to 1.9x in the second quarter of 2020 due to a sharp decline in EBITDA during the COVID-19 pandemic. However, the net leverage for EM IG remains low relative to U.S. IG (Figure 8).

Figure 8: Net Leverage (EM IG versus DM IG)

Source: JP Morgan. As of 12/31/2020

Conclusion

EM Corporate bonds offer investors an attractive risk-return profile for an asset class that is only going to continue to grow and evolve as EM countries continue to develop and benefit from globalization. The market offers attractive yield in a low yield environment. Diversification is key when allocating to EM Corporates to minimize concentration and default risk. Thus, active management is important to maximize alpha. Given minimum trading sizes and sporadic bouts of illiquidity, choosing an established manager with a diversified vehicle is important to efficiently take advantage of the growing opportunity set that is EM Corporate debt.

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This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

The JP Morgan Emerging Market Bond Index Global Diversified (EMBI) is a uniquely weighted version fo the EMBI Global. It limits the weights of those indexcountires with larger debt stocks by only including specified portions of these countries eligible current face amounts of debt outstanding. The JP Morgan Global Bond Index - Emerging Markets Global Diversified (GBI-EM) tracks total returns for US dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities. The JP Morgan Corporate Emerging Market Bond Index Broad Diversified (CEMBI) tracks total returns for US dollar-denominated debt instruments issued by corporate Emerging Market countries.Past performance is no guarantee of future results. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio.

Past performance is no guarantee of future results. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio.