EM Corporates – Time to Dip Your Toe In? – May 2018

Following the recent sell off in EM corporate bonds, has the short duration segment reached an attractive entry point?

The recent bout of volatility and resultant sell off in emerging market (EM) corporate bonds has been in our view largely due to another round of geopolitical concerns, as well as single-country event risk.

Yet geopolitical risk is a feature of all risk assets. The move higher in US Treasuries is just part of the normalisation of monetary policy in the US, which we believe is justified and in keeping with macroeconomic backdrop in the country. Duration risk is also something that exists in all fixed income assets – not just EM corporate bonds.

However, what we believe this recent price action highlights is the resultant impact it has had on the EM corporate bond market and the attractive entry point it has created.

As Fig. 1 indicates, yields on the short duration bond index have edged higher. We believe this now represents an attractive entry point into the asset class (yields move inversely to prices).

Fig. 2 – Valuations Appear Attractive on a Relative Basis

Source: ICE BofA Merrill Lynch, Bloomberg, Muzinich & Co, as of 11 May 2018. You cannot invest directly in an index, which also does not take into account trading commissions or costs.

 

In addition, based on our internal analysis, valuations have fallen (Fig. 2), and the asset class currently looks cheap, especially relative to Western markets.

However, this does not mean that EM corporate bonds are cheap because the fundamentals have deteriorated and therefore the risk has increased.  In our view, the fundamental investment case for EM remains intact and robust.

EM economies are benefiting from the synchronised global growth backdrop, where companies in sectors such as commodities, technology and shipping are benefiting from the pickup in global trade. Political risk has also largely improved on the whole – notably in the Korean peninsula, although there will always be pockets of uncertainty. Rising commodity and oil prices are also proving positive for EM companies and countries.

Meanwhile we believe EM company fundamentals remain solid, with more cash on their balance sheets compared to their developed market peers (such as US high yield) while capital structures are generally considered simpler, again relative to developed markets.

Therefore, while duration risk is rising, we believe an allocation into the short duration segment of the EM corporate bond market can offer investors the benefits provided by an allocation into EM corporate bonds, but in an area that is likely to be less impacted by rising interest rates.

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