Accessing an underinvested asset class against a backdrop of improving growth can provide investors a better risk-reward profile than developed market credit.
Emerging Markets (EM) debt is a large and well-diversified asset class; the hard currency universe (comprising corporate and sovereign debt) exceeds US$2 trillion and offers investors a rich opportunity set across sectors, countries and ratings.
Yet despite an overall reduction in political and geopolitical risk, and a move to a reflationary environment where EM is a primary beneficiary (EM GDP is trending upwards), investors continue to be underweight the asset class on a global basis; over $350bn away from the 2013 peak (source: Institute of International Finance).
We believe EM debt can provide investors a number of benefits and now is a good time to consider an allocation.
1. Attractive Risk-Reward Profile
EM corporates tend to have lower leverage and more cash on their balance sheets than their developed market (DM) peers, but are penalised in terms of spread.
However, based on our analysis, investors are better compensated per unit of risk (turn of leverage) in EM corporate debt compared to similar-rated credits in DM. In particular, we see the most exciting opportunities in BBB and BB rated credits where investors are paid nearly double for the same level of risk than their DM counterparts (Fig. 1).
Fig. 1 Global EM Spread Per Turn of Leverage
Source: BofA Merrill Lynch, EM Corporate Credit Chart Book, as of May 31st 2017
2. Improving Fundamentals
Since the 2013 Taper Tantrum, EM sovereigns have been strengthening their balance sheets. We have also witnessed an increase in business-friendly policies in large EM countries such as Argentina and Brazil, an overall decrease in political and geopolitical risk in EM and more stability in commodity markets.
As Fig. 2 shows, the fundamental picture of EM sovereigns now appears more robust; current accounts are positive in aggregate with EMs a net global lender, while FX valuations are somewhat cheap. Therefore, EM sovereigns are more attractive from an investment perspective.
Fig. 2 EM Sovereign Fundamentals have Strengthened
Source: Haver Analytics, Bloomberg Finance LP, Deutsche Bank, as of May 31st 2017
We believe the fundamentals of EM corporates are also on an improving trajectory. Following a weak 2-year period from 2014-2016, where corporate earnings were negative (hit by a sell-off in commodities, extremely weak FX and poor growth), we have seen a turnaround in all three variables.
Fig. 3. EM Corporate YoY EBITDA & LTM EBITDA Growth %
Source: Bank of America Merrill Lynch Monthly Chart Book, as of May 31st 2017
These positive dynamics have led to a turnaround in corporate earnings (Fig. 3) which should in turn lead to a reduction in leverage, ratings upgrades and the lowering of defaults; the market expects default rates to end the year at 1.25%, down from a 5% peak in 2016.*
Over the same 2-year period, multiple EM crises (e.g. Russia, Brazil, commodities) resulted in the downgrade of approximately $100bn of the investment grade universe. Nevertheless, this has ultimately had a positive effect on these credits; only the strongest survived and these companies have spent the past two years strengthening their balance sheets. Against a backdrop of strong growth, rising corporate earnings and deleveraging, we expect these ‘rising star’ credits to be upgraded over time.
An allocation into EM bonds offers investors exposure to an investible universe well diversified by sector, sovereign and rating. In Fig. 4, we believe the benefits of incorporating an EM debt allocation into your portfolio is evident; it increases the efficient frontier without increasing risk or volatility.
Fig. 4. Incorporating EM Improves the Efficient Frontier
Source: Merrill Lynch Indices H0A0 – US High Yield Index, HEC0 – Euro High Yield Constrained Index, EMHB – Emerging Market External Sovereign, from 31.01.99 – 31.12.16
The size of the universe also means investors have access to over 50 economies at different stages of the economic cycle, which offers the ability to navigate away from sectors or countries where the risk profile is rising.
Although we do not anticipate any extreme catalysts that could derail the current positive momentum in credit markets, there are a number of risks of which we should be aware. These include sudden and unexpected changes in central bank policy in the US and Europe, and China’s ongoing balancing act between financial stability and maintaining growth. There is also political risk; while we have seen an overall reduction of political risk in emerging markets, EM by its nature is a more politically-volatile asset class. Consequently, we will be closely monitoring situations such as the corruption scandal dominating Brazil, political turmoil in South Africa as well as the possibility for further sanctions in Russia. In addition, there are ongoing concerns surrounding the global macroeconomic picture where productivity is unusually low, debt is high and central banks have little room left for policy manoeuvrability.
With that said, we expect the benign investment environment to continue for the foreseeable future. While central bank rhetoric is becoming increasingly hawkish, changes are likely to be slow, measured and well telegraphed. We also expect fundamentals to continue to improve with ongoing deleveraging in both sovereign and corporate markets and upgrades to outpace downgrades. At the same time, we believe the hunt for yield and investors’ underweight exposure to EM and a net negative supply (outside China) in the corporate space should strengthen the technical dynamic.
Focus on Fundamentals
While we have demonstrated the benefits of an allocation into EM debt, the associated risks mean a deep focus on bottom-up, fundamental analysis should underpin any investment decisions. An investor should take into consideration the strength, depth and expertise of an asset manager’s investment capabilities and ensure they have a rigorous investment process that aims to select the best credits while providing downside protection.
* Source: Bank of America Merrill Lynch, as of May 31st 2017
Past performance is not a guide to future performance. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Where references are made to portfolio guidelines or features, these may be subject to change over time and prevailing market conditions.
The prices of fixed income securities fluctuate in response to perceptions of the issuer’s creditworthiness and also tend to vary inversely with market interest rates. The value of such securities is likely to decline in times of rising interest rates. Conversely, when rates fall, the value of these investments is likely to rise. Typically, the longer the time to maturity the greater are such variations. A Fund investing in fixed income securities will be subject to credit risk (i.e. the risk that an issuer of securities will be unable or unwilling to pay principal and interest when due, or that the value of a security will suffer because investors believe the issuer is less able or willing to pay).
Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only.
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