While it is too early to describe it as a mature market, it provides a variety of alpha-generation opportunities.
From an overall risk allocation perspective, the ability to express the theme of rising domestic demand complements existing emerging market hard currency allocations, but with less volatility than emerging markets equity.
Private consumption trends will continue to expand and provide alpha-generation opportunities in the corporate marketplace. A rising working-age population, a growing middle class, and improving outcomes in health and educational attainment have significant implications for consumer sectors and industries.
As GDP per capita increases in response to rising living standards, more companies will access the capital markets to expand investment and support the growth in demand for goods and services, including the retail and food industries.
Expanding market
The number of companies available to emerging markets corporate bond investors has doubled in the post-financial crisis years. Some of the stimulus to the market’s growth was enforced by Western banks’ contracting balance sheets and tightening lending standards, encouraging companies to seek better rates and more attractive terms in capital markets. The longer-term issuance of bonds provides a more sustainable financing option for companies.
The sharp increase in debut issuers in the year to date is affecting the regional composition of the index. Emerging Europe and the Middle East and Africa are growing market share, while Asia and Latin America have declined. Turkey has increased its market share from 1.75 per cent in 2010 to 4.33 per cent in 2013. The JP Morgan Corporate Emerging Markets Bond Index Broad Diversified now comprises 43 countries, including new frontier entrants such as Mongolia.
Investors can gain indirect exposure to the growth story of frontier markets via corporate bonds. For example, as the China export cycle peaks, Chinese port operators are expanding operations to new destinations, including Nigeria and Togo, to capture the potential expansion in commodity and export growth.
Strong fundamentals
Credit quality fundamentals in emerging markets companies are strong. Credit, sovereign and liquidity risk factors are priced into emerging markets corporate bonds – building an attractive premium relative to other fixed income sectors.
The average emerging market credit rating is mid-BBB, while 70 per cent of the asset class is rated investment grade, compared with less than 50 per cent in 2001. There have been a higher proportion of debut high-yield issuers this year, highlighting the increasing credit quality diversity of the market.
In spite of a fairly robust credit rating profile, credit risk premiums are higher in the emerging market corporate bond sector, as standards in corporate governance and transparency are less consistently applied across countries and companies.
Initiatives such as Basel III are helping, but there is room for progress. Recovery rates are lower in emerging markets, while offshore borrowers lack seniority in the event of bankruptcy resolution in some countries. On average, however, companies domiciled in emerging countries hold higher cash positions and lower debt burdens than those in developed markets. The current default rate in emerging markets high yield – forecast to be 1.5 per cent in 2013 versus 2 per cent for US high yield – is expected to stay low as access to liquidity improves.
Investing in emerging markets corporates should not be viewed as a top-down allocation; careful security selection is required. Credit research needs to encompass rudimentary corporate bond analysis, such as leverage on the balance sheet, cash flows and capital expenditure plans.
However, it should also include input from sovereign and equity research analysts. Sovereign risk is always a consideration in emerging markets, so emerging markets corporate credit ratings tend to be subject to the sovereign ‘cap’ or ‘ceiling’ – implying they cannot be rated higher than their sovereign country. The macroeconomic input is important as it considers companies’ operating environments, including political, regulatory, and economic risks.
With structural and cyclical economics favouring emerging market countries, consumerism is a significant long-term investment theme. Investors can take advantage of the shifting balance of global growth in corporate debt markets.
Michael Conelius, portfolio manager at T.Rowe Price
