Analysis  |  October 8, 2021

Emerging Markets Corporates Vs. Sovereigns Lower Risk, Better Return?

Traditionally viewed as ‘riskier’ assets, emerging market (EM) corporate bonds tend to have a higher Sharpe ratio and higher credit ratings than their sovereign counterparts. In a post-pandemic world, what might this mean for those considering an EM allocation?

For investors looking for diversification and exposure to the economies of Asia, Latin America, Eastern Europe and the Middle East, an allocation to the emerging market (EM) hard currency sovereign universe may be the obvious choice. It provides exposure to over 50 countries at different stages of economic development, and lower volatility due to the lower currency risk.

However, we believe the EM hard currency corporate universe is a more attractive asset class than its sovereign counterpart. It’s a multi-asset global opportunity set, providing investors the ability to rotate into different regions, sectors and sub-asset classes.

As outlined below, the corporate universe also offers additional benefits compared to the sovereign market.

Fig. 1 – Asset Class Sharpe Ratios

Source: JP Morgan Emerging Markets Corporate Strategy Presentation published September 21st, 2021. For illustrative purposes only.

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

Equities are lower down the capital structure, and local currency bonds are hurt by currency fluctuations. Both are therefore more volatile, which reduces their Sharpe ratio.

Unlike developed market bonds, EM assets are not separated into investment grade and high yield. Therefore, investors do not have to rotate their allocation over the economic cycle during periods where high yield or investment grade do better.

US Treasury rallies are also already priced into EM corporates, unlike asset classes such as US high yield.

Fig. 2 – Characteristics

Source: ICE Index Platform. ICE BofA Emerging Markets External Sovereign Index (EMGB) and ICE BofA Emerging Markets Corporate Plus Index (EMCB), as of 30th September 2021. For illustrative purposes only.

A look at the underlying composition of the corporate and sovereign markets also explains why the corporate segment is potentially more attractive.

Sovereigns have a larger distressed bucket and more duration risk than corporates, yet the yields are similar. Therefore, sovereign investors are not being compensated for the additional duration and credit risk.

Fig. 3 – EM Corporates Have a Lower Beta than EM Sovereigns

Source: ICE Index Platform. ICE BofA Emerging Markets External Sovereign Index (EMGB) and ICE BofA Emerging Markets Corporate Plus Index (EMCB), as of 6th September 2021. For illustrative purposes only.

To get the same EM exposure, investors only take half the beta by allocating to the corporate market (Fig. 3). This is also played out in the total return of both asset classes (Fig. 4).

EM corporates have generally performed better over 5 years because of their lower beta during periods of market volatility. Investors are potentially paid a higher return with lower volatility for choosing corporate risk over sovereign (Fig. 5). Therefore, in our view there is little rationale to owning sovereigns.

Fig. 4 – EM Corporates Versus Sovereigns – Total Return

Source: ICE Index Platform. ICE BofA Emerging Markets External Sovereign Index (EMGB) and ICE BofA Emerging Markets Corporate Plus Index (EMCB), as of 30th September 2021. For illustrative purposes only.

Fig. 5.  5yr Efficient Frontier Between EMGB & EMCB

Source: ICE Index Platform. ICE BofA Emerging Markets External Sovereign Index (EMGB) and ICE BofA Emerging Markets Corporate Plus (EMCB), as of 30th September 2021. For illustrative purposes only.

Leverage - Falling versus Flat

EM corporates are also in a strong position from a fundamental perspective. The reopening of economies following Covid-19 has led to a huge increase in economic growth. Higher volumes and stronger prices have resulted in greater revenue streams.

Corporate leverage is expected to return to levels not seen since 2011 (Fig. 6) and this is likely to result in an increase in rising stars. The opposite is true in the sovereign space (Fig. 7).

Fig. 6. – Corporate Leverage

Source: JP Morgan Emerging Market Corporate Strategy published September 21st, 2021. For illustrative purposes only. Forecast based on JP Morgan projections.

Fig. 7. Sovereign Leverage

Source: Bloomberg/IMF data as of October 6th, 2021.GOVDEMER Index (IMF Emerging Market & Developing Economies General Government Gross Debt % GDP) and GOVDDCG7 Index (IMF Major Advanced Economies (G7) General Government Gross Debt % of GDP). For illustrative purposes only. Forecast based on IMF projections.

While EM sovereigns may be the more familiar asset class, we believe there is a stronger case for owning EM corporates. As noted herein, they have a higher Sharpe ratio, are less volatile, have a lower beta, are higher ratings and have benefitted from the post-pandemic recovery. As a result, EM corporates offer a compelling investment opportunity in our view.

Muzinich & Co. views and opinions as of September 30th 2021, and subject to change without notice.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of September 2021 and may change without notice.

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Index Descriptions

EMCB - The ICE BofA ML Emerging Markets Corporate Plus Index tracks the performance of the U.S. dollar and euro denominated emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets. Qualifying issuers must have risk exposure to countries other than members of the FX G10, all Western European countries, and territories of the U.S. and Western European countries.

EMGB – The ICE BofA ML Emerging Markets External Sovereign Index tracks the performance of US dollar and euro denominated emerging markets sovereign debt publicly issued in the major domestic and eurobond markets.  Qualifying securities must have risk exposure to countries other than members of the FX-G10, all Western European countries and territories of the US and Western European countries.

EMHB - ICE BofA High Yield Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities rated AAA through BBB3, inclusive.

EMIB - – The ICE BofA ML High Grade Emerging Markets Corporate Plus index is a subset of the ICE BofA ML Emerging Markets Corporate Plus Index (EMCB) including all securities rated AAA through BBB3, inclusive.

You cannot invest directly in an index, which also does not take into account trading commissions or costs. The volatility of indices may be materially different from the volatility performance of an account.