The emerging market (EM) corporate bond cynics have been very vocal of late. If you were to believe them, an impending implosion of the market seemed all but inevitable. Yet the apocalypse didn’t come. Here, we debunk three of the popular myths about EM corporate bonds.
They’re risky and there are a lot of defaults.
The risk profile for EM corporate debt is generally considered to be about the same as US high yield debt. This is in spite of the fact that most EM corporate debt is investment grade. In reality, companies in emerging markets default on their debt far less frequently than companies in the US high yield market. Indeed, the default rate for US high yield companies is expected to be around 6% this year, while for emerging market companies it is expected to be barely 1.5%, according to J.P. Morgan. What’s more, the figure for EM defaults has exceeded 3% only once in the last 20 years, and that was at the height of the financial crisis. Back then, the default rate in US high yield was more 12%. People also tend to have the impression that EM corporates are small, niche names. And while some are, many aren’t.
The amount of debt which has been issued is a hazard in itself.
People are worried about the amount of hard currency corporate debt coming from emerging markets. While it has increased, the amount doesn’t look dramatic when you provide a bit of context. In Asia, external corporate debt has gone from 2% to 4% of GDP. It’s a similar story elsewhere. In Latin America, the percentage has risen from 4% to 9%; in the Middle East and Africa, from 4% to just 7%. These are very manageable numbers – meaning that even if they suffered a complete lockdown in external financing (an unlikely scenario), the impact should be contained.
The ‘technicals’ of the market are a mess.
Supply and demand drives any well-functioning market. New issuance (i.e. supply) was only about $240 bn over the last twelve months, a figure 35% lower than the previous year. Money coming back into the market through interest and amortization was close to $200 bn last year, meaning the net finance required – the amount of new bonds being issued to the market – was only about $40 bn.
While companies in developed markets have been returning excessive cash to shareholders through share buybacks and spending on mergers and acquisitions, EM companies have been using their excess cash differently. Last year we saw a record amount of bond buybacks in emerging markets: almost $40 bn. If you include that number, then the net finance required for EM corporates was close to zero. And that figure could turn negative during 2016 if year-to-date issuance is anything to go by.
Emerging market corporate debt is perceived as risky but is actually investment grade.
The attractiveness of EM corporate debt comes from three factors. First, interest rate sensitivity is low--duration is less than five years. Second, it terms of quality it is often perceived as being akin to high yield, yet it is actually investment grade. And third, yields are north of 5.5% – a figure that is pretty hard to match from investments with a similar risk profile.
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), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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 are enhanced in emerging markets countries.