March 2021 / INVESTMENT INSIGHTS
Seeking Alpha in Emerging Markets Corporate Debt
After a decade of strong performance, the asset class deserves a serious look
- Emerging markets (EM) corporate debt is now a larger market than U.S. high yield or EM sovereigns, with over USD 2.5 trillion of bonds across 60 countries.
- Thanks to an average BBB‑ rating and generally healthy fundamentals, the asset class generated a 5.8% annualized return for the decade until December 31, 2020, with relatively modest drawdowns.1
- A benchmark‑agnostic but risk‑aware approach allowed the Emerging Markets Corporate Bond Strategy to outperform the index over one, three, and five years as of December 31 2020.2
Corporate debt is the fastest‑growing area of hard currency emerging markets (EM) debt, with almost USD 2.5 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 December 31, 2020, due to the broadly healthy balance sheets of most EM companies and a tilt toward investment‑grade (IG) Asian markets.
Going forward, we expect to see sustained opportunities in EM corporate debt as new issuers should 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 potentially generate meaningful alpha for our clients.
Diverse Sources of Alpha
T. Rowe Price uses a benchmark‑agnostic but risk‑aware approach to select IG and high yield 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.
(Fig. 1) Size of Global Bond Sectors
EM debt offers investors a large and diverse opportunity set.
Debt outstanding, as of December 31, 2020
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 December 31, 2020, by capturing diverse sources of genuine excess return rather than relying on carry or excessive portfolio concentration.
As of December 31, 2020, the EM corporate debt universe encompassed over 750 companies across 60 countries. Since 2011, the market has grown an average of 15% per year, fueled by numerous debt issuers, unlike the stable to shrinking U.S. high yield and EM sovereign debt markets.
(Fig. 2) Risk and Return Profiles
EM corporate bonds have featured relatively strong risk‑adjusted performance.
December 31, 2010, Through December 31, 2020
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%.
In the first quarter of 2020, EM corporates3 experienced a monthly maximum drawdown of 11.5%, while other EM asset classes declined 13%–20%.
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.
(Fig. 3) EM Corporate Debt Ownership
Different buyer bases potentially allow managers to exploit regional inefficiencies.
Debt outstanding, as of July 31, 2019
(Fig. 4) Contributions to Excess Returns for Emerging Markets Corporate Bond Representative Portfolio
Most sectors and half of EM countries contributed meaningfully to positive performance.*
Five Years ended December 31, 2020
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.
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, prior to the coronavirus pandemic, members of our teams were taking nearly 200 research trips a year to gain local knowledge that can create a competitive edge—a pace they hope to resume as soon as conditions normalize.
In addition, T. Rowe Price’s trading resources help us identify potential price dislocations while helping ensure 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.
A Disciplined, Risk‑Aware Investment Process
To achieve their objectives, our EM corporate bond professionals employ a five‑step
Our investment process is designed with two goals in mind:
- to identify diverse and repeatable sources of alpha, and
- to avoid permanent capital impairment due to default.
(Fig. 5) Performance
The Emerging Markets Corporate Bond Full-Authority Composite outperformed its benchmark.
Five Years Ended December 31, 2020, in USD, Gross of Fees
(Fig. 6) Upside/Downside Capture vs. Peer Group
The strategy seeks to overweight high yield in up markets while avoiding weaker credits in drawdowns.
December 31, 2015, through December 31, 2020
Positive 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 December 31, 2020. 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 half of countries contributed meaningful amounts of excess return over the five years ended December 31, 2020, with most of these positions adding 20–100 basis points, gross of fees, over that period.
Up/down market capture results reflect a similar pattern. Over the five years ended December 31, 2020, 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.
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.
GIPS® Composite Report
Emerging Markets Corporate Bond Full-Authority Composite
Period ended December 31, 2020. Figures are shown in U.S. dollars
Emerging Markets Corporate Bond Full-Authority Composite.
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