The COVID-19 pandemic has exposed sharp differences in economic performance between countries and regions. Emerging market countries, especially in Asia, have been notably resilient. As the glut of global liquidity sends investors in search of yield, we see opportunities in emerging market corporate debt. This asset class provides a spread pick-up over US corporate equivalents, while enjoying stronger fundamentals and offering greater diversification benefits across multiple geographies.
Asia has been a notable outperformer
The COVID-19 pandemic has accentuated economic growth differences across many regions of the world. Although first affected by the crisis, Asia has become a notable outperformer and even succeeded in posting positive economic growth over the second quarter. On the other hand, developed market (DM) economies have been particularly hard hit, with GDP collapsing by as much as 23% over the same period. This decline is even far in excess of the worst performing emerging market (EM) region, Latin America, which saw its GDP fall by close to 13% (Figure 1).
Figure 1: GDP growth % (by region)1
The balance of payments is not (yet) an issue
While the balance of payments (BoP) is usually the channel through which crises in EM emerge, this is not the case today. EM current accounts are in a healthy position on aggregate. While Latin America does have a deficit, elsewhere current accounts are in surplus (Figure 2).
Figure 2: Current account balances % (by region)2
Fiscal deficit increases will require a solid exit plan
EM governments have faced the same challenges as governments the world over after implementing large spending programmes in order to sustain demand. While some countries like Brazil and South Africa have run up large fiscal deficits, that picture is not uniform across EM. Some countries in emerging Asia have fiscal positions that certain developed economies could only dream of – highlighting again the diversity of economic realities across EM (Figure 3).
A key challenge facing EM governments, and governments in developed markets (DM) also, lies in exiting this period of fiscal excess. Issues of debt sustainability are coming under question for some of the weaker EM economies as well as heavily indebted DM economies.
Figure 3: Fiscal deficit (% GDP) of selected EM countries3
The search for yield reignited
While the glut of global central bank liquidity has been instrumental in propping up asset prices, it has also driven yields lower (Figure 4, Figure 5). This has reignited a search for yield from investors as many DM government bond curves turn negative. These technical dynamics are overwhelming, dwarfing everything else from a fundamental point of view. While the economic implications of the COVID-19 pandemic have had clear negative implications, the wall of liquidity has been exceptional.
The sheer size of US corporate credit and municipal bond markets mean they dominate the credit opportunity set available to global investors and serve as natural first destinations for yield-searching investors. However, they lack geographic diversity being exposed to a singular economic risk in the shape of the US economy.
Figure 4: G4 central bank balance sheets (US$, PPP conversion)4
Figure 5: Negative yielding bonds in global aggregate (% trillions)5
EM corporate debt: a compelling opportunity
Diversified across more than 60 economies
It has been well articulated that EM corporate debt is a material asset class, with current assets outstanding of US$2.4trn (Figure 6). However, in the current market environment it is important to look at other less well articulated characteristics. It does not have the singular country risk of the US credit market, but in fact benefits from the geographic and economic diversity on offer from the more than 60 economies spread across multiple continents.
Figure 6: Global fixed income asset classes (US$ trn)6
Favourable yield and duration characteristics
For investors searching for positive income in hard currency, EM corporate debt offers an attractive yield at a lower average duration than US equivalents. For 4.9 years of duration, it offers 4.59% of yield. This compares with 8.8 years and 2.03% respectively for US aggregate credit (Table 1).
Table 1: Yield and duration comparison7
|Barclays indicies||Base FX||Base FX Yield||Duration (yrs)|
|Global aggregate credit||USD||1.65%||7.4|
|Euro aggregate credit||EUR||0.57%||5.3|
|Sterling aggregate credit||GBP||1.77%||8.0|
|US aggregate credit||USD||2.03%||8.8|
|JPM EM indices|
|EM IG corporates||USD||3.05%||5.5|
|EM HY corporates||USD||6.84%||4.0|
|External IG sovereigns||USD||2.98%||9.3|
|External HY sovereigns||USD||8.16%||6.3|
An investment grade-rated asset class
A commonly held misconception about EM corporate debt is that it is a high yield (HY) asset class with weaker fundamental than their US and European counterparts. This is not the case. 58% of the investment universe is investment grade rated, leading to an overall rating of BBB. EM corporates also employ lower levels of leverage, and if anything, they have entered this crisis on a stronger footing after reducing leverage over the last number of years. They have achieved this by selling assets to buy back debt, while also engaging in liability management exercises to extend their debt maturity profile during favourable market conditions.
We expect default rates to remain contained
While we do expect leverage to increase over the coming months, this is more likely to be a factor of EBITDA8 being lower given lower economic growth rather than higher indebtedness. These lower debt levels, combined with EM corporates’ proactive refinancing efforts last year during favourable market conditions and strong support from EM governments on the fiscal side, should lead to relatively contained default rates this year.
Defaults year to date have only been 2.9% of the EM HY universe, compared to 6.0% in US HY. EM HY defaults are expected to rise to just 3.5% for the full year 2020, versus 6.5% for US HY. This remains well below the 5.1% of last crisis and 10.8% of the 2008 crisis.
Figure 7: Global IG net leverage comparison9
Figure 8: Global HY net leverage comparison10
Higher spread despite stronger fundamentals
Despite EM corporates’ comparatively stronger fundamentals, it offers a spread pick-up over US corporate credit. As Figure 9 shows, EM corporate credit’s spread per turn of leverage exceeds that of US credit across regions and ratings buckets. Taking a look at BBB-rated bonds for example, Latin America and Emerging European, Middle East and African (Emerging EMEA) BBB EM corporate bonds provide 117bp and 174bp per turn of leverage, compared with just 66bp for US BBB-rated corporate bonds.
Figure 9: Spreads per turn of leverage11
Poor ESG scoring companies have higher default risk
Finally, it is important to recognize the crucial role that ESG considerations play in EM corporate bond analysis. This is something that’s borne out by the evidence.
Looking at EM corporate defaults over the past 5 years, we have found that the biggest contribution to defaults has been issuers with poor ESG scores. The worst 20% ESG scoring companies were responsible for 70% of the defaults over this period. Therefore, ESG analysis is clearly not a tick-boxing exercise but an important tool to produce alpha and manage risk.
At Insight, we actively engage with the companies we are dealing with. We send companies an ESG questionnaire to see how ESG is managed at these companies, as well as the overall direction of travel. Applying ESG in an ex-ante method to EM corporates arguably has a greater impact than merely relying on ex-post scores, an approach that is very compelling to investors in our view. ESG is fully integrated into our investment process, and we believe that the role it plays in credit risk analysis is as important as debt metrics analysis.
COVID-19 has laid bare the risks and challenges that many economies around the world face. EM economies, particularly in Asia, have been notably resilient. With the glut of global stimulus likely to keep yields suppressed for a long period to come, investors should consider the lesser explored corners of the investment grade hard currency credit universe, such as EM corporate credit, for gains in yield and diversification.