May 2020 / INVESTMENT INSIGHTS
EM Corporate Debt’s Time Has Come
Its role in investor portfolios is set to expand
Emerging market (EM) corporate debt is still regarded by many as a niche investment and is consequently not as prominent in portfolios as other asset classes. That could be about to change, however. As investors position their portfolios to benefit from the post‑coronavirus economic recovery, EM corporate debt’s unique combination of characteristics could make it increasingly in demand.
Not only has EM corporate debt benefitted from the secular trends that make EM in general an attractive place to invest, it also has features that distinguish it from other forms of EM investment. Its mix of historically attractive yields, relatively low duration, and low correlation with sovereign bonds make it an attractive option for investors seeking to boost the performance and diversify the risk of their bond and multi‑asset portfolios.
Emerging Markets’ Triple Premium: Growth, Demographics, and Change
Emerging markets should benefit from a “triple premium” of three key factors: growth, demographics, and change. The growth premium relates to the pace of the economic growth of emerging markets, which has recently converged with the peak growth rate of developed markets during the 1980s and—as predicted by the International Monetary Fund—should remain at this level over the next few years.
At the same time, the economic expansion of developed economies has settled at a lower level than in the past, partly for structural reasons and partly because developed market economic cycles have become longer. Since 2000, emerging markets have consistently grown at a higher pace than developed markets and although the emerging market economic expansion has slowed in recent years, it still offers a growth premium over developed economies.
The demographics premium exists because the percentage of the population aged 65 and above in emerging markets is the same as it was in developed countries back in the early 1970s. This gives EM countries an advantage over the developed world: Not only do emerging markets benefit from a younger workforce and better dependency ratio, they also have populations that are growing faster where there is a higher fertility rate.1 Moreover, the coronavirus crisis is likely to have a larger impact on the older populations of developed markets than on the younger populations of some emerging economies.
Several developments provide emerging markets with a change premium. Chief among these is that the moderation of inflation in emerging markets means that EM central banks should be able to ease monetary conditions in coming decades to stimulate growth because they do not need to keep rates high to battle inflation. Lower inflation and accommodating central banks should support lower bond yields over the long term. The potential for falling rates should boost EM asset prices, while a fall in interest rates and lower borrowing costs should support corporations.
Other structural changes that should benefit EM assets include the fundamentally improved growth and fiscal discipline of EM governments and improving corporate governance. The structure of many of these economies has also changed as they have shifted from being dominated by industrial production and natural resources to having more balanced economies, including a thriving services sector. These changes should support emerging economies and corporations operating in them.
The Unique Characteristics of EM Corporate Bonds
There are several ways to invest in emerging markets: through equities, sovereign debt (which can be denominated in either local or hard currency), or corporate bonds. We believe EM corporate bonds offer unique properties that mean they are well positioned to perform well in several different scenarios.
Figure 1 shows the duration (x axis), yield (y axis), and correlation with global equity (the size of the bubble indicates the magnitude of correlation; blue is the positive and, orange is the negative correlation). The most obvious conclusion from the chart is that not all fixed income asset classes are alike—they can have short or long duration (i.e., different sensitivities to changes in interest rates), low or high yields, and low or high correlation with equities (i.e., some are conservative assets that may diversify equity risk, while others are not).
EM corporate bonds offer an attractive yield, nearly on par with that of high yield bonds and EM hard currency sovereigns. The duration of the EM corporate bond index is shorter than that of EM and developed market (DM) government bonds and most DM investment‑grade corporate bonds. The average credit quality of EM corporates is BBB-, as is that of EM hard currency sovereigns, while that of global high yield is BB—in other words, EM corporate and sovereign bonds have an average investment‑grade credit rating. The lack of CCC rated credit and frontier market‑issued bonds in EM corporates means that the asset class has lower structural tail risk than EM hard currency sovereigns and high yield bonds.
Duration, Yield, and Correlation With Equities
(Fig. 1) Fixed income is a heterogeneous asset class
The relatively short duration and high carry should allow EM corporate credit to perform well in both environments of modestly rising or falling rates. When rates rise, carry could buffer some losses due to duration risk—rates need to rise by about 0.9% to generate capital losses at current yield levels. When rates fall, returns could come from both carry and duration.
The profile of the EM corporate debt market has been improving over time: At the start of 2020, about 70% of EM corporate debt was investment grade, compared with less than 40% at the start of 2000.3 This improvement in credit quality has been driven by two main factors: first, by the fundamental improvements in EM countries and companies arising from growth and fiscal discipline, and second, a compositional change in the index as higher‑quality Asia corporate debt has accounted for nearly all net supply since 2015. If these trends continue, the spreads between EM bonds and DM bonds will narrow over time, providing another potential boost to the performance of EM corporate bonds.
Because EM corporate bonds are denominated in U.S. dollars, they carry no currency risk for dollar‑based portfolios. For non dollar‑based portfolios, the currency can be either easily hedged (given liquidity of U.S. dollar) to the portfolio’s base currency or left unhedged (given the appetite for U.S. dollar exposure). As the U.S. dollar is a safe‑haven currency, U.S. dollar exposure could mitigate drawdowns during some stressful economic scenarios.
(Fig. 2) EM corporates offer highest ratio of yield to duration
As Figure 2 shows, EM corporate bonds offer the highest ratio of yield to duration of all the bond indices shown.
EM corporate bonds also offer a wide investment opportunity set—the index includes over 1,600 constituencies from over 50 countries—and it is less researched and efficient compared with its DM counterparts. EM corporate debt spans a universe of issuers with different macroeconomics, countries, sectors, durations, and credit qualities. These features offer more opportunities for active management to potentially add value over and above the performance of the index.
Role in a Portfolio Context
EM corporate bonds are correlated with global equities. They are therefore a risk asset and would not hedge equity risk as effectively as high‑quality, long‑duration DM government bonds. However, while EM corporate bonds have shown strong, equity‑like performance, they have also exhibited lower risk than other growth assets, such as high yield, while they offer diversification benefits, in particular, with DM government bonds.
Performance of Bonds and Stocks Since 2001
(Fig. 3) EM corporate debt has delivered equity‑like returns
As Figure 3 shows, since 2001, the cumulative performance of EM corporate debt has been on par with that of global equities but with visibly lower volatility. Income is the leading component of total return in many asset classes over the long term, so the relatively high coupons of EM corporate bonds have helped to contribute to the strong returns of the asset class.
Since 2002, EM corporate bonds have had only three years of negative returns, two of which with returns not worse than -1.5%. The only year with a significant drawdown of nearly 17% was 2008—the year of the global financial crisis—but in the following year, there was a significant rebound of over 37%. So far in 2020, EM corporate bonds are down about 8%. Long‑term investors who do not panic because of a single bad year have been rewarded for investing in EM corporate bonds over time.
The long‑term correlation of EM corporates with global equity is 0.59 and with EM equity is 0.62.4 While the correlations are positive, they are still imperfect, meaning EM corporates bring diversification benefits when mixed with stocks. Since 2004, EM corporates have exhibited lower volatility than global equities and, for the most part, global high yield bonds (which only exhibited lower volatility than EM corporate bonds during very calm market environments).5 However, it is important to note that during periods of stress, the correlation of EM corporates with stocks tends to rise.
Because of their low correlation with global government bonds, adding some EM corporate bonds to a portfolio could—perhaps counterintuitively—mitigate risk. Figure 4 shows different mixes of global DM government bonds and EM corporate bonds. Allocating 10% to EM corporates and 90% to global DM government bonds reduces risk while increasing past and potential performance; allocating 20% to EM corporate bonds only marginally increases volatility.
Blends of Government Bonds and EM Corporate Bonds
(Fig. 4) Adding EM corporates can reduce risk and improve performance
Risk vs. Reward
EM corporate bonds offer the potential for strong returns because of high yields, potential for capital appreciation, and alpha from active management, as well as diversification benefits in portfolio context. It is a risk asset, correlated with global equities. Investors in EM corporates should consider their volatility and drawdowns, as well as the risks of investing in emerging markets, such as political risk and legal standards of corporate governance and accounting practices still converging toward established conventions in developed markets. Nevertheless, active management and careful selection could mitigate risks, helping investors to reap the benefits of the asset class.
What we’re watching next
We are closely following the ongoing developments of the coronavirus crisis and its impact on both developed and emerging markets. As the level of uncertainty is high, it is still too early to comprehend all the potential outcomes of the crisis. However, valuations of many risk assets, including EM corporate bonds, have become more attractive than they were before the onset of the crisis. While we may not have seen the bottom of the market, buying risk assets that are not yet bottomed out could be appropriate for some long-term investors who have a healthy risk appetite and a properly diversified portfolio.
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