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January 2017

EM corporate bonds: Where income still flows

EM corporate bonds are a rare source of income in a low yield world.

Emerging market corporate bonds are a beacon for investors struggling to find sufficient income. Not only do they offer the sort of yields that have all but disappeared elsewhere, but they’re underpinned by solid economic fundamentals. And because these bonds  mature sooner on average than their sovereign emerging market counterparts, they’re better placed to weather rising global interest rates.

In a world starved of income, emerging market (EM) corporate bonds are coming into their own. Yields are some of the  highest available among the major fixed  income asset classes. In fact, they’re only surpassed by those on EM local currency debt and US high yield credit.

This makes EM corporate particularly attractive given how abnormally compressed spreads have become across much of the rest of the fixed income universe – and the huge volume of negative yielding developed government and top-rated European corporate debt.

The broad index of EM corporate bonds – the JPMorgan CEMBI broad diversified – offered yields of 5.4 per cent at the end of December, substantially above those on offer from US and European investment grade bonds and the European high yield credit market.
Investors have noticed. EM corporate bonds had posted total returns of some 9.7 per cent in 2016, the best performing part of the corporate credit universe apart from US high yield. What’s more,  EM corporate bonds have weathered the very recent shakeout in global bonds better than most other classes of fixed income.

Solid fundamentals underpin EM corporates

In part, EM firms are able to deliver solid income thanks to relatively strong and stable economic growth in their home countries. We expect emerging economies to deliver 4.3 per cent GDP growth in 2017, compared with just 1.8 per cent in the developed world, extending a trend that’s evolved over the past couple of years. Meanwhile, emerging market inflation has been falling, giving central banks scope to ease monetary policy and spur growth.
Premium growth
Change in GDP on previous year
emerging market inflation, ease monetary policy

Source: Pictet Asset Management, CEIC, Datastream. Forecasts from 2016. 

Solid economic fundamentals help to underpin EM corporations’ creditworthiness, which is usually better than at of equivalently-rated developed market borrowers. And, significantly, that quality comes at a discount because EM company bonds trade at wider spreads. 

To some, this differential boils down to domestic sovereign risk premia. Some observers argue that the discount is justified because, unlike their developed country counterparts, EM companies’ creditworthiness can be constrained by the actions of their governments. And yet with close analysis it’s possible to find companies that are relatively insulated from domestic factors.

For example, a number of Turkish corporate bonds we’ve been invested in since before last summer’s coup attempt weathered the country’s subsequent political upheavals thanks to their strong fundamentals. They maintained their investment grade credit ratings even though the sovereign was downgraded by Moody’s. 

It’s ironic that EM corporates should be disentangling themselves from sovereign factors at a time that their developed economy counterparts are so heavily under the sway of their domestic central banks. 

Weathering bond market volatility

Recent market volatility reflects concerns that there could be a general move towards tighter monetary policy in the developed world. Investors are still digesting the significance of the Bank of Japan’s recent shift from targeting quantities of assets purchases to controlling the level of Japanese yields. There is talk the European Central Bank could start tapering next year. And the US Federal Reserve in broadly expected to keep tightening policy at a steady pace after raising rates in December. 

So far the fallout to EM corporate bonds has been relatively modest. Yet if monetary conditions become significantly less friendly, EM corporate bonds should fare better than, say, their sovereign counterparts, which are far more sensitive to changes in interest rates. 

The yield offered by EM corporates is comparable to that on hard currency EM government bonds, but with substantially shorter duration, at 4.8 years compared to 7 years for the sovereign debt. 

EM corporate bonds stack up well against the alternatives, given a mix of shorter duration and solid yield, together with default and recovery rates1 that are broadly in line with developed market counterparts.

Worrying less about dollar borrowing

Meanwhile, technical factors are also increasingly favourable for the asset class. Hitherto, various observers – including the International Monetary Fund – have flagged concerns about booming dollar borrowing among EM corporates. A major concern is what happens to EM companies’ ability to service their debts if the dollar starts to rise on the back of tighter Fed policy. But while gross supply of EM corporate paper has remained relatively high, recently much of it has been used to refinance existing debt. Net new issuance dropped substantially in 2015 and only partially recovered in 2016. 
less than it seems
Gross and net EM corporate annual supply
EM corporates new issuances high

Source: BofA Merrill Lynch Global Research as at 07.01.2017

What’s more, the impact of a rising dollar on the market isn’t universally negative. It’s true that the greenback’s strength makes it harder for firms that borrow in dollars but generate revenues in local currencies to service their debts. But companies with dollar-denominated borrowing which also sell dollar-priced goods and have local currency costs (often commodity producers) will tend to benefit from a stronger US currency. 

Bottom up management

Notwithstanding the generally favourable macro and technical backdrop for EM corporates, we protect our investors from the vagaries of both global economic forces and idiosyncratic political risk by focusing on bottom up company analysis. This allows us to find interesting prospects in even unfriendly environments.

What’s more, because they are largely held by institutions, which tend to be less subject to rapid shifts in sentiment than retail investors, EM corporate bonds tend to be less volatile than, say, EM sovereign debt. 

Our current positioning is built of a combination of defensive positions – which include Chinese and Indian oil and gas names – investments with prospects of intermediate returns, including Turkish non-financials and Russian names likely to benefit most from the country’s recovery, and more ambitious holdings geared more heavily into a global rebound, like Latin American energy names and Brazilian industrials.
fielding winners
How our portfolio is positioned
EM corporates portfolio position

Source: Pictet Asset Management, as at 01.01.2017