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Emerging markets corporate debt: coming of age

Here’s an asset class that continues to defy the odds. Despite concerns of high debt levels, growing geopolitical risks and sluggish global growth, emerging-markets (EM) corporate debt has once again delivered another year of impressive results.

This year sees a continuation of many of the same challenges we saw in 2016, including uncertainty over what Donald Trump’s U.S. presidency will look like. Anyone hoping that Trump’s campaign promises were just talk won’t have been overly encouraged thus far. While it’s too still early to gauge which of his policies he’s genuinely serious about, his message of “America First” has been made loud and clear. The Republican Party does not have a history of being trade protectionists though, so it’s likely that this rhetoric will be dialed back over the coming months.

But it’s not all about Trump. And among the uncertainty also lies great opportunity. EM corporate debt has grown significantly since the global financial crisis. It’s developed in a number of ways besides its size. Prospects vary across and within the differing EM regions, but EM nations are home to some of the fastest-growing companies globally. There are a number of reasons for investors to consider this asset class:

  1. Debt levels

EM net leverage remains below U.S. peers

Source: BAML, 31  Dec 16. For illustrative purposes only. Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.

Since the end of the global financial crisis, EM companies had been gearing up in anticipation of continued success and high levels of growth. However, headwinds facing the global economy saw profitability decline, which left a number of companies highly leveraged, especially in the mining and energy sectors. These concerns subsequently led to a rethink in business strategy. The end result is that EM companies’ balance sheets are now much improved, especially when compared to their U.S. counterparts. Attention has shifted away from a focus on cheap debt to efficiency and cost-optimization programs. Business models, which were largely shaped around expansion, are now focusing on return generation and sustainability. This in turn should translate into stronger cash flow and a quicker deleveraging process.

In short, the boom years are over, and these companies are well aware.

 

  1. A Growing Opportunity

Source: JP Morgan, 31 Dec 16. For illustrative purposes only

Relative to other asset classes, the size of the EM corporates universe is greater than other segments of the global credit markets, including the U.S. high-yield market and EM external sovereigns. Growth over the last decade has been staggering. The establishment of the JP Morgan Corporate Emerging Markets Bond Index (CEMBI) in 2007 has helped EM corporate debt become an asset class in its own right, rather than simply a sub-sector of EM debt.

EM countries continue to offer fertile ground for corporates to succeed. Attractive demographics, a growing middle class, and large labor forces will remain drivers of domestic demand.

EM corporate debt market vs other markets

Source: JP Morgan, 31 Dec 16. For illustrative purposes only

  1. Profitability remains strong

EM companies continue to offer a more attractive return on the risk/reward spectrum relative to their U.S. peers, and this trend has been accelerating over the last few years. A common misconception among investors is that these bonds are rated below investment grade. Instead, it’s a well-diversified asset class, with 60%[1] of bonds having investment-grade ratings. So EM corporate debt is not only higher quality than in the U.S., but it’s also less exposed to default risk. This is backed up by a recent JP Morgan report, which predicts that the EM default rate will decline to just 0.8% in 2017.

Source: JP Morgan, November 2016. For illustrative purposes only. Note: default rates are dollar-weighted; HY (high yield); YTD (year-to-date); F (Forecast). Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

  1. Low yields in developed markets

In 2016, EM bonds experienced vast inflows as the “great migration” from developed markets (DM) to EM took place. Even the big institutional investors were making their move. Ultra-low yields in DM were a primary reason. More than two-thirds of European bonds still yield less than 1%, while the average yield of the JP EMU index is just 0.49%. The European Central Bank is likely to remain accommodative for the foreseeable future, extending the current quantitative easing program at its latest meeting by nine months to December 2017. In the U.S., the U.S. Federal Reserve (Fed) raised interest rates by 25 basis points (bps) in December. The market expects another three rate hikes in 2017, but even if this were to happen, rates would still be at historically low levels. 

EM corporate bonds still offer an attractive solution as investors continue to broaden their hunt for yield.

Indices used: DM Sovereign: JPM GBI; European Sovereign Index: JPM EMU For illustrative purposes only.

Source: JP Morgan, November 30, 2016. Figures may not add up to total due to rounding.

  1. Strong long-term performance

 

Over the past 10 years, the JP Morgan Corporate Emerging Market Bond Index has delivered a cumulative return of 108.25% and an annualized return of 6.40%. This compares favorably to other global bond indices. When combined with the robust credit fundamentals of EM companies, still growing underlying economies and manufacturing indices that are ticking higher, EM corporates seem to be on a positive path to greater success.

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.