European High Yield - October

The inclusion of Emerging Markets in High Yield indices

Back on the 9th of September, Standard & Poor’s cut Brazil’s external sovereign debt to junk and kept the market on watch with a negative outlook. The following day, S&P announced the downgrade of 31 Brazilian corporates, of which Petrobras was the highest profile issuer. Rating agencies usually apply a direct relationship between EM country rating and domestic-based company rating, such that a country downgrade is often associated with a subsequent series of company downgrades.

Why do I bring this up? First, the trend for macro fundamental deterioration in a number of emerging markets (EM) countries has the potential to push a large number of EM corporate bonds into the high yield universe over the next three years. There is already evidence that this is happening with euro-denominated issues from EM companies now making up 10% of the European high yield index. That’s doubled from the average share of close to 5% seen in recent years (see figure 1). In its 2015 annual survey, Bank of America Merrill Lynch (BofAML) focused on this new trend and asked whether its high yield indices should continue to include EM issuers. The results of the survey released at the end of July, concluded that EM issuers should continue to be included but that a number of specific high yield sub-indices should also be created to specifically exclude EM corporates.

My second remark has to do with bottom-up credit research. We are convinced at T. Rowe Price that we cannot expect an emerging markets corporate analyst to make accurate recommendations without benefiting from a clear sovereign debt assessment of the country. As a result, we encourage our dedicated EM corporate analysts to collaborate with our sovereign EM analysts when evaluating opportunities from a company standpoint, and the recent Brazil episode is a good reminder of why this approach is ultimately the most suited when investing in these kinds of markets.

From a management perspective, the inclusion of a growing number of EM issuers in various high yield indices is creating new challenges in terms of risk management. While I do not try to replicate any benchmark weight since I rely mostly on bottom-up idea generation, I remain cognizant of the influence that the EM complex may have at times of risk aversion. Indeed, the potential impact of EM names is becoming more acute because liquidity can become sporadic at times when the country itself is under scrutiny.

I believe in looking at the widest investment opportunity set for our clients, and for that reason I do not want at this stage to omit corporates from the EM segment. Whether BofAML excludes EM issuers from the benchmark does not change ultimately their potential impact on markets. However, it is another reason why collaboration and sharing of information is important, not only within our credit team, but also with our sovereign colleagues.

Figure 1

2015-GL-2708