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Seeking Alpha in Emerging Markets Corporate Debt

Samy Muaddi, Portfolio Manager, Emerging Markets Corporate Bond Strategy

Executive Summary

  • Emerging markets (EM) corporate debt is now a larger market than U.S. high yield or EM sovereigns, with over USD 2 trillion of bonds across 50 countries.
  • Thanks to an average BBB‑ rating and generally healthy fundamentals, the asset class generated a 6.9% annualized return over the past decade, with modest drawdowns.1
  • A scarcity of dedicated EM corporate investors, inefficient markets, and labor‑intensive research needs create alpha opportunities across cycles, in our view.
  • A benchmark‑agnostic but risk‑aware approach allowed the Emerging Markets Corporate Bond Strategy to outperform at the composite level over the three and five years ended June 30, 2019.

Corporate debt is the fastest‑growing area of hard currency emerging markets (EM) debt, with almost USD 2.3 trillion outstanding and new issuance averaging 15% of debt outstanding per year since 2011. The asset class generated strong risk‑adjusted returns over the five years ended June 30, 2019, due to the broadly healthy balance sheets of most EM companies and a tilt toward investment‑grade Asian markets. During 2018, when other emerging markets assets—particularly equities and local currency debt—suffered notable sell‑offs, the EM corporate market proved relatively resilient.

Going forward, we see sustained opportunities in EM corporate debt, as new issuers continue to come to market and the asset class becomes more widely held among institutional investors. Additionally, we believe the asset class offers many opportunities for bottom‑up fundamental managers such as ourselves to generate meaningful alpha for our clients.

Diverse Sources of Alpha

T. Rowe Price uses a benchmark‑agnostic but risk‑aware approach to select investment‑grade (IG) and high yield (HY) positions that we believe have the potential to outperform the broader market over the medium term. As we evaluate the approximately 1,300 companies in our investment universe, we focus on corporate governance; liquidity; detailed financial and strategic analysis; and environmental, social, and governance (ESG) considerations to help us identify outperformers and avoid credit distress.

This systematic approach allowed us to outperform at the composite level both our benchmark and our eVestment peer universe over the three and five years ended June 30, 2019, by capturing diverse sources of genuine excess return, rather than relying on carry or excessive portfolio concentration.

(Fig. 1) Size of Global Bond Sectors

EM debt offers investors a large and diverse opportunity set.
Debt outstanding, as of July 31, 2019

EM debt offers investors a large and diverse opportunity set. Debt outstanding, as of July 31, 2019

Sources: J.P. Morgan (see Additional Disclosures), Bloomberg Index Services Limited (see Additional Disclosures), and MSCI (see Additional Disclosures).

EM sovereign: J.P. Morgan Emerging Markets Bond Index Global; EM corporate: J.P. Morgan Corporate Emerging Market Bond Index Broad Diversified; EM local: J.P. Morgan Government Bond Index—EM Global Diversified; U.S. IG corporate: Bloomberg Barclays U.S. Corporate Investment Grade Index; U.S. high yield: Bloomberg Barclays U.S. High Yield Index; EM equity: MSCI Emerging Markets Index.

As of June 30, 2019, the EM corporate debt universe encompassed over 1,300 companies across 52 countries. Since 2011, the market has grown an average of 15% per year, fueled by numerous debut issuers, unlike the stable-to-shrinking U.S. high yield and EM sovereign debt markets.

Higher credit quality, USD denomination, and a structural tilt toward Asia made EM corporate debt among the most defensive EM assets during recent market corrections. In 2018, for example, the J.P. Morgan CEMBI Broad Diversified declined 2% while most other EM assets declined 5%–15%.

(Fig. 2) Risk and Return Profiles

EM corporate bonds have featured relatively strong risk‑adjusted performance. July 31, 2009, Through July 31, 2019

EM corporate bonds have featured relatively strong risk‑adjusted performance. July 31, 2009, Through July 31, 2019

Past performance is not a reliable indicator of future performance.

Sources: J.P. Morgan (see Additional Disclosures), MSCI (See Additional Disclosures), Bloomberg Index Services Limited (see Additional Disclosures).

U.S. investment grade = Bloomberg Barclays U.S. Investment Grade Index; EM sovereign = J.P. Morgan EMBI Global Index; EM corporate = J.P. Morgan CEMBI Broad Diversified; U.S. high yield = Bloomberg Barclays U.S. High Yield Index; Euro high yield = Bloomberg Barclays European High Yield Index; EM equity = MSCI Emerging Markets Index.

EM Corporates Offer Diversification Potential

While many institutional investors currently do not have strategic allocations to EM corporate debt, the asset class offers meaningful potential diversification benefits relative to many widely held institutional assets, particularly commodities, core fixed income, and U.S. equities.

In addition to generating attractive risk‑adjusted returns at the index level, a closer examination of the EM corporate debt universe shows that different regions historically have offered significantly different risk/return profiles, allowing investors to calibrate their exposures throughout a market cycle.

Very different domestic buyer bases also potentially allow active managers to exploit technical inefficiencies across regions. In Asia, large numbers of local buyers historically have tended to provide support during market sell-offs, generating a more defensive return profile. In Latin America, by contrast, foreign investors—including U.S. crossover investors—dominate the market, making for more frequent technical dislocations.

(Fig. 3) EM Corporate Debt Ownership

Different buyer bases potentially allow managers to exploit regional inefficiencies. Debt outstanding, as of July 31, 2019

Different buyer bases potentially allow managers to exploit regional inefficiencies. Debt outstanding, as of July 31, 2019

Source: J.P. Morgan (see Additional Disclosures).
Not including unidentified securities. Normalized to total 100%.

(Fig. 4) Contributions to Excess Returns for Emerging Markets Corporate Bond Representative Portfolio
Most sectors and countries contributed meaningfully to positive performance.
Three Years Ended June 30, 2019

Most sectors and countries contributed meaningfully to positive performance.

Past performance is not a reliable indicator of future performance.

The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from those of other accounts in the strategy. Please see the GIPS® Disclosure page for additional information on the composite. Sector classifications based on T. Rowe Price internal classifications.

Source: T. Rowe Price.

Versus the J.P. Morgan CEMBI Broad Diversified.

Global Research and Trading Capabilities

To exploit this opportunity set, T. Rowe Price has built truly global research and trading platforms. We believe our commitment to on‑the‑ground research and value‑added trading gives us the ability to identify and thoroughly evaluate ideas across regions as the opportunity set shifts. 

In our view, it is difficult, if not impossible, to fully assess an EM corporate bond issue without understanding the home country’s politics, economics, and equity markets. Therefore, members of our EM corporate debt team often travel with our sovereign debt and equity analysts, collaboratively sharing their views on a given country and its issuers. Our teams typically make over 200 visits to emerging markets each year.


A Disciplined, Risk‑Aware Investment Process 
To achieve their objectives, our EM corporate bond professionals employ a five‑step investment process.

A Disciplined, Risk‑Aware Investment Process

In addition, T. Rowe Price’s trading resources help us identify potential price dislocations while ensuring that we are adequately compensated for providing liquidity to the market and can execute trades during local market hours across the globe. Although our security selection process primarily is based on company fundamentals, our quantitative analysis team and our enterprise risk team both help us evaluate and hedge systematic risk.

Our investment process is designed with two goals in mind:
 

  • to identify diverse and repeatable sources of alpha,
  • to avoid permanent capital impairment due to default.

     

Positive Three‑ and Five‑Year Performance Results

Over time, our investment process enabled the Emerging Markets Corporate Bond Strategy at the composite level to generate a positive return stream, with only a few periods of notable underperformance as of June 30, 2019. We have achieved these results primarily through principal appreciation and by avoiding defaults, rather than simply out‑carrying the benchmark.

Decomposing attribution by sector and country sheds some light on how returns were generated. Consistent with our approach, there were no outsized detractors while most sectors and countries contributed meaningful amounts of excess return over the three years ended June 30, 2019, with most positions adding 20–100 bps over that period.

Opening Quote Over time, our investment process enabled the Emerging Markets Corporate Bond Strategy to generate a positive return stream, with only a few periods of notable underperformance. Closing Quote

(Fig. 5) Performance 
The Emerging Markets Corporate Bond Representative Portfolio outperformed its benchmark.
Three Years Ended June 30, 2019, in USD, Gross of Fees

 

Past performance is not a reliable indicator of future performance.

Source: T. Rowe Price.

The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from those of other accounts in the strategy. Please see the GIPS® Disclosure page for additional information on the composite.

Up/down market capture results reflect a similar pattern. Over the three years ended June 30, 2019, the strategy outperformed at the composite level by a large margin during up markets by selectively overweighting high yield credits while avoiding the weakest parts of the market during drawdowns.

(Fig. 6) Upside/Downside Capture Versus Peer Group

The strategy seeks to overweight high yield in up markets while avoiding weaker credits in drawdowns.
June 30, 2016, Through June 30, 2019

The strategy seeks to overweight high yield in up markets while avoiding weaker credits in drawdowns.

Source: eVestment Alliance, LLC. eVestment peer universe = EM corporate bond managers excluding high yield-only, investment‑grade‑only, and short‑duration‑only strategies.

1eVestment data for the second quarter of 2019.

What we’re watching next

In our view, the past few years have demonstrated that EM corporate debt is an underowned asset class that offers potentially attractive risk‑adjusted returns at the index level as well as many potential opportunities for outperformance through security selection.

Over time, we expect that the asset class will become more widely embraced by institutional investors as the U.S. high yield market shrinks and the size and depth of the EM corporate opportunity set become better understood.

Credit rating and 10‑year return are for the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified, as of June 30, 2019.

Additional Disclosure

Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2019, J.P. Morgan Chase & Co. All rights reserved.

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS  is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’ licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI and its affiliates and third-party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

GIPS Disclosure 

 

Risks—the following risks are materially relevant to the portfolio:

China Interbank Bond Market risk—Market volatility and potential lack of liquidity due to low trading volume of certain debt securities in the China Interbank Bond Market may result in prices of certain debt securities traded on such market fluctuating significantly.
Country risk (Russia and Ukraine)—In these countries, risks associated with custody, counterparties, and market volatility are higher than in developed countries.
Credit risk—A bond or money market security could lose value if the issuer’s financial health deteriorates.
Default risk—The issuers of certain bonds could become unable to make payments on their bonds.
Derivatives risk—Derivatives may result in losses that are significantly greater than the cost of the derivative.
Emerging markets risk—Emerging markets are less established than developed markets and, therefore, involve higher risks.
Frontier markets risk—Small-market nations that are at an earlier stage of economic and political development relative to more mature emerging markets typically have limited investability and liquidity.
High yield bond risk—A bond or debt security rated below BBB- by Standard & Poor’s or an equivalent rating, also termed “below investment grade,” is generally subject to higher yields but to greater risks too.
Interest rate risk—When interest rates rise, bond values generally fall. This risk is generally greater the longer the maturity of a bond investment and the higher its credit quality.
Liquidity risk—Any security could become hard to value or to sell at a desired time and price.
Sector concentration risk—The performance of a portfolio that invests a large portion of its assets in a particular economic sector (or, for bond portfolios, a particular market segment) will be more strongly affected by events affecting that sector or segment of the fixed income market.


General Portfolio Risks

Capital risk—The value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.
Counterparty risk—An entity with which the portfolio transacts may not meet its obligations to the portfolio.
Geographic concentration risk—To the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.
Hedging risk—A portfolio’s attempts to reduce or eliminate certain risks through hedging may not work as intended.
Investment portfolio risk—Investing in portfolios involves certain risks an investor would not face if investing in markets directly.
Management risk—The investment manager or its designees may at times find their obligations to a portfolio to be in conflict with their obligations to other investment portfolios they manage (although in such cases, all portfolios will be dealt with equitably).
Operational risk—Operational failures could lead to disruptions of portfolio operations or financial losses.


Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

 

201908-937435

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T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

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