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Why should investors consider Emerging Markets Corporate Bonds?

Samy Muaddi, Portfolio Manager, Emerging Markets Corporate Bond Strategy

Why should investors consider the asset class?

There are three reasons investors in Australia should consider an allocation to emerging market corporate debt. The first would be coupon. The second would be, durable alpha proposition, and the last would be defensive downside characteristics. A brief comment on each of those.

With respect to the coupon, you have a five and a half percent income stream today, an asset class that has delivered 6.5% annualised returns, but in a higher quality form. Emerging market corporates does not have a much of an allocation at all to the lower rungs of credit quality, such as frontier markets or CCC credit. So, you're harvesting more premium in the middle of the risk category, BB and BBB ratings, but taking less risk down the capital stack.

Secondly, on durable alpha. The top quartile of emerging corporate debt managers have produced more alpha than other credit categories, and that just speaks to the inefficiencies that are still latent within the market as a newer and less sponsored asset class.

And then just lastly with respect to the downside protection in the last 10 year period, the worst annual draw down in an emerging market corporate credit was just barely over 1% and that goes back to the inverse of a higher quality coupon that I referenced earlier. So in a world where you can obtain a coupon in high yield and emerging sovereign, emerging local or emerging corporate, I would suggest that plans take that allocation in a more defensive way versus taking some of the greater draw down risk that's evident in similarly yielding asset classes.

How has EM bonds performed vs EM equities?

I find a lot of Australian plans own very large allocations to emerging market equity in comparison to debt. That does stick out versus other parts of the world. It is sensible given the resident currency, given the proximity to China. However, let's take a step back and move away from theory and just look at returns. Because the theory is such that stocks outperform bonds over the long term. And while that's true in Australia, while that's true in the United States and Europe, it has not been true in emerging markets for the 30-year history of the asset class.

A dollar invested in emerging market bonds would have produced twice the return of emerging market equities over the last 25 years. Because in the hard currency bond space, you're not taking on the currency risk, and you have a much more defensive draw down profile, or you're preserving your capital better in a down-market. A bad year for equities, you may be down 20% or 30%. A bad year for bonds, you're down just a few percentage points. So, it's very difficult to take a high coupon, compound it, and beat that return. That's just an essential principle of investing that I think is often missed when I analyse the construct of today's allocations in Australia.

How could a portfolio benefit from an allocation?

If an investor were to make an allocation to emerging market corporate today, cyclically, I think this could be an opportunity to de-risk your plan. Either de-risking emerging market equity into emerging market hard currency fixed income. Or potentially de-risking your credit allocations, taking money out of private credit, out of US high yield, which has a very large CCC allocation, and putting that into emerging market corporate credit. All those alternatives that I referenced are actually de-risking your plan, but maintaining a high level of income, which we all know is important in a low yielding world.


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201908-937768
 

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