EM corporate debt: A misunderstood asset class

When it comes to investing in emerging markets (EMs), there are long held assumptions and biases that often go unchallenged. And with corporate defaults likely to rise in both developed and emerging markets over the next 12-18 months, investors will need to be clear-headed and sighted.

Take EM corporate debt, which has grown out of the shadows of the EM Sovereign / Hard-Currency bond market, has expanded significantly since the global financial crisis. From a starting base of approximately USD 500 billion in 2008, the asset class has grown five-fold to USD 2.5 trillion at the end of 2022.

It is now largely an investment-grade market. Strong fundamentals, attractive valuation and improving secondary market trading volumes have also led to a broadening of the investor base. However, many investors still incorrectly ascribe certain weak market dynamics, factors and considerations to an asset class that has clearly evolved over recent years. Below we try to tackle some of these myths head on.

True. Over 70 percent of the debt issued by emerging market companies is rated investment-grade, making it far less niche than historically. Indeed, recent performance data suggest that EM IG corporates move more in line with their developed market investment-grade peers than with EM HY corporates; something reflected in the correlation between the two asset classes.

Basic industries such as oil and gas as well as metals and mining have traditionally made up a large proportion of the benchmark. However, as the asset class has matured the concentration risk from these two sectors has been mitigated by larger weightings of consumer goods/staples, industrials, infrastructure and utilities.

Figure 2. Outstanding EM external corporate debt

In terms of the regional breakdown, issuers from Asia have grown in prominence the most. Representing little over a third of the total debt stock at the end of 2008 Asian issuers now account for just over half (as at the end of 2022). This is perhaps unsurprising given the region’s relatively strong economic growth over that period. And while the shares of Latin America and Middle East and Africa are little changed, Emerging Europe declined from over a quarter to one tenth of the total. Development and growth of domestic capital markets within Emerging Europe has led to local currency bonds and bank credit replacing hard-currency US dollar corporate debt.

Figure 3. EM external corporate debt issuers by region

True. Net leverage for the asset class has gone from 1.4 times in 2012, to around 2.5 times. This was largely driven by idiosyncratic events in Latin America in 2015-2016 and has settled back to 1.4 times by the end of 2022. Gross margins have been stable in the mid-20% range while interest-coverage ratio, despite the interest rate hikes in the US, is at a 10-year high of over 11 times.

EM corporates, especially those rated investment grade, have in general grown revenues and earnings at a faster pace than their developed market peers. Default expectations for EM corporates have come off the elevated levels seen in 2021 and 2022 which were dominated by the China property sector and are now more in line with historical rates.

Figure 4. Strengthening leverage, interest coverage

The biggest paper and pulp producer in Latin America demonstrated that EM companies can pierce sovereign credit ceilings. This Brazilian company, has a BBB- rating, an investment grade rating that is three notches above Brazil’s sovereign rating of BB-.

Furthermore, the asset class has even been resilient even in cases of sovereign defaults. Take Argentina and Ukraine in 2020 and 2022, respectively. While the corporate bonds sold off in line with the respective sovereign initially, they either avoided default or restructured with generally higher recovery rates when compared to their respective sovereigns.

True. Despite better fundamentals, EM corporate bonds tend to trade at a discount to their developed market peers. As of mid-August 2023, EM corporate IG-credit trades approximately 50 basis points wider than US corporate IG-credit peers, while the high-yield spread gap is currently around 100 basis points. Credit rating agencies have always been more conservative with their ratings for EM corporates which suggests that adjusted for ratings, the spread differential is even more favourable. EM corporates have been penalized on most metrics for simply being in the wrong zip code.

Figure 5. EM spread gap is wider than DM

In addition to appealing valuations and lower default rates, technicals have been favourable of late too. For 2022 and YTD-2023, bond issuance net of amortizations, coupon payments and corporate actions has been negative, thereby creating an upward bias on existing bond prices.

Figure 6. Negative bond issuance

True. It used to be the case that once a bond issued by an EM corporate was purchased it had to be held to maturity as the secondary market did not have much depth or in some cases the market simply did not exist. As the market and investor base has matured, trading volumes for EM corporate bonds, currently at USD 2.75 billion daily as per TRACE data, have certainly improved but still not at levels commensurate with their developed market peers.

Split by region, bonds issued by Latin American corporates are traded the most, followed by Asian corporates and finally CEEMEA corporates. The rise of electronic trading platforms such as MarketAxess and TradeWeb which offer a diversified pool of liquidity is also helping boost trading volumes.

True. The Sharpe ratio, which describes how much excess return you receive for the volatility of holding a riskier asset, for EM corporates is significantly above the EM sovereign hard-currency market. The asset class has delivered positive returns in 17 out of the past 21 years.

Furthermore, EM corporates universe, as represented by JP Morgan’s CEMBI, has the highest Sharpe ratio over the past 20 years when compared to a broad range of asset classes. The return profile is attractive but what makes it even more interesting is that it has been achieved with lower volatility.

Figure 7. Sharpe ratio by asset class

Source: UBS Asset Management, Bloomberg, 2003-2022

When viewing EM investment opportunities, investors should judge credits on the underlying merits, not their zip code. EM corporate fundamentals are robust with net leverage ratios at historic lows, strong profit margins, and healthy interest coverage ratios. Returns from the asset class have been attractive and current valuations appear to offer a good entry point.

The macroeconomic backdrop also seems benign: major central banks are closer to ending their rate-hike cycle, soft-landing narrative is gaining momentum and additional Chinese stimulus cannot be ruled out. Inflation which has been a key issue over the last two years seems to be trending lower across the world. Economic conditions as indicated by the purchasing manager’s indices indicate expansion across regions.

However, there exists idiosyncratic risks like those in the China property sector, which is why it is prudent to invest with an active investment manager that has in-depth experience through the credit cycle. A deep bench of seasoned portfolio managers and on-the-ground research analysts is vital to developing a nuanced view of the emerging markets corporate opportunity set.