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Emerging Markets

Emerging market credit: an oasis for yield-thirsty investors

December 2017

Alain-Nsiona Defise, Head of Emerging Corporates

Emerging market credit can deliver attractive returns and low volatility even as prospects for other bonds turn cloudy, says Alain-Nsiona Defise in a Q and A

The Pictet-Emerging Corporate Bonds strategy is now five years old. How has the asset class changed over the past half a decade?

The most obvious change has been rapid growth. The emerging market (EM) credit market has expanded by more than 50 per cent since 2012 to reach USD1.4 trillion (see chart). That has gone hand-in-hand with a broadening of the universe: the asset class is represented by more companies and more countries than ever before. It is becoming too big and too important an opportunity for investors to ignore.

a sizeable and growing opportunity

Outstanding external EM corporate debt (estimated, in USD billion)

EM flows
Source: Bank of America Merrill Lynch, as of 31.10.2017

But size isn’t everything. There have also been more subtle – but no less important – structural changes. The market has become more mature in terms of how it responds to local crises. What would have caused widespread panic in years gone by is now more often viewed as an isolated incident. When trouble erupted in Russia and Brazil earlier this year, for example, the rest of the market was largely unaffected. This reduction in systemic risk is very important to the overall resilience and stability of EM credit.

Much of the market’s recent growth has been fuelled by Asia. Why is that and what does it mean for investors?

The growth in Asia reflects deep-seated changes in the behaviour and needs of the region’s corporations and investors. On the one hand, as the region’s economy has expanded and private enterprise has been given more freedom, the number of potential bond issuers has increased. On the other hand, demand has also grown rapidly, with cash-rich Asian investors seeking the relative stability of foreign currency assets alongside the familiarity of investing within their domestic market.

Asia’s rise has been very positive for EM credit as a whole. Asian companies tend to have higher ratings than their peers in other regions, and have increased this advantage over the past five years. Their default rates are also very low – and not just compared with other emerging market borrowers. In fact, since 2013, default rates among speculative-grade Asian borrowers have been lower than those of their US counterparts. For investors, Asia’s rise therefore not only means greater diversification but also more stable returns.

The global backdrop is becoming tougher for bonds as central banks begin to rein in monetary stimulus. How will emerging corporate credit fare?

Emerging markets might not be the first port of call for investors when times get tougher, but emerging corporate debt is actually in a very strong position to withstand any turbulence in the broader global bond market and to continue to be an attractive source of both income and capital gains, as well as a good diversifier. 

attractive value

Spread per turn of leverage, basis points/debt-to-EBITDA ratio: EM and US corporate bonds 

EM spread

Source: Bank of America Merrill Lynch, as of 31.10.2017 

That's because such securities generally have shorter maturities and higher coupons than other major types of debt. This means their duration – or sensitivity to rising interest rates – is lower, at 4.9 years, compared with EM sovereigns’ dollar denominated debt at 6.9 years and US investment grade debt at 7.4 years.1 Low duration should offer valuable protection as the US Federal Reserve and other major developed market central banks tighten policy over the coming months and years.

Secondly, the economic backdrop is very supportive for emerging markets. Our economics team forecasts that developing economies will grow 5.0 per cent in real terms in 2018 – more than double the 2.1 per cent expected for developed markets.

Thirdly, the pricing for emerging credit is not as stretched as for some other fixed income assets, meaning they have more scope to absorb rising yields while still generating attractive returns. One of our valuation methods is to look at credit spreads per turn of leverage – or how much yield investors receive relative to how indebted the company is. On that basis, these bonds consistently offer better value than US corporate debt (see chart). And, because emerging market corporate debt is not a homogenous universe, there is even better value to be found in some areas, such as some B-rated Latin American bonds.

Finally, the investor base is very solid. It is dominated by institutions, which tend to have a longer investment horizon. At the same time, potentially volatile exchange-traded funds (ETFs) make up only a small proportion of the EM credit market.

Where, within EM credit, do you see the most attractive opportunities for next year?

We like to look at our portfolio as a football team – a mix of positions with different characteristics which, when combined in the right way, can deliver the best possible results.

picking the right players

Select investment positions of the Pictet-Emerging Market Credit strategy

Source: Pictet Asset Management, as of 30.11.2017

In our line-up, the defence -- or the anchor for the portfolio -- features, among others, non-cyclical companies, such as a Saudi utility whose creditworthiness and ability to generate steady cashflow should remain strong even at times of economic downturns. The midfield is made up of issuers that offer greater capital appreciation potential over the medium term, and includes consumer and mining firms. Finally, our strikers are our more ambitious holdings with the greatest potential over the long run but also a bit more risk. Here, we particularly like Nigerian financial companies. They have a long track record of bond issuance, attractive fundamentals and resilience to oil price fluctuations that could affect other parts of the Nigerian debt market.

Over the past five years, the emerging credit market has grown, diversified and matured. It has also proved its ability to deliver attractive levels of income alongside capital gains. With the right line-up of investments, we believe the potential for the next five years could be even greater.