EMCD: corporate attractions

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With attractive headline yields providing a cushion against rising US Treasury rates and buoyant default expectations at a time of heightened global uncertainty, this might be a watershed moment for emerging market corporate debt (EMCD).

An anticipated c5.6% in total return expected for this year from emerging market corporate bonds could be a silver lining for fixed income investors this year, says Rodica Glavan, head of emerging market corporate debt at Insight. Especially as 2021 has started the year with close to record low yields across many asset classes.

Even as the year started optimistically, investors have been skittish – unsettled by some events, such as the final days of Donald Trump’s presidency and rebounding on the optimism of vaccines. Expectations of a strong fiscal package in US have pushed up growth forecasts and hence interest rates higher, sending some jitters through tight credit spread markets everywhere. Glavan says: “We think emerging market (EM) corporates can withstand an increase in US Treasury yields as long as the Fed remains accommodative and the main reason for higher core rates is stronger growth. Higher US Treasury yields have already been incorporated in the 5.6% total return expectations for this year, as attractive carry and spread compression on cyclical growth upswing more than balancing out negative contribution from US Treasuries.”

Glavan notes that with the US election over, the outcome offers positives for EMCD this year such as a more predictable trade policy from the incoming US administration. While Glavan doesn’t believe Joe Biden will reverse some of the protectionist policies already in place, he is likely to adopt a more cooperative approach across emerging market governments, especially China.

China is a key component of the recovery in emerging market debt and EMCD, says McDonagh, noting the economy is of greater significance and influence on emerging markets than the US. “Some 65% of the increase in Chinese imports from May to December last year came from emerging markets,” he cites, pointing out this highlights the shift in dependencies in the region.

In addition, he says: “Typically a crisis of growth in emerging markets involves a balance of payments issue – not so this time. While there has been a significant weakening in exchange rates since the crisis began, it is not the reason for a decline in import demands.” This is why McDonagh and the Insight team believe companies across such regions are well situated to bounce back from the pandemic economic crisis. While the pandemic affected the EMD universe as much as it did every asset class, and at a greater level than the 2008 crisis, McDonagh also notes the shock was less for emerging than developed markets. He attributes this to lower debt levels in many emerging markets ahead of the crisis.

Defaults in EMCD in 2020 were half the rate in US HY: 3.5% vs 6.8%, and are expected to stay below 3% for 2021, according to Insight. By comparison, according to the group’s figures, EMCD defaults reached 5.1% during the difficult 2015-16 period and 10.5% in the 2009 crisis. “Moreover, and encouragingly, the EM corporate recovery rate has been at 42% in 2020, relatively high both by historical standards and compared to US HY, where it was around record lows of around 20%,” she adds, citing stats from JP Morgan as at January 2021.

One of the reasons for lower default rates in the EMCD universe has been the lower net leverage across emerging markets companies compared to developed market ones, for both high yield and investment grade-rated companies (See Figure 1), she points out.

Combined with lower expected defaults is the anticipation of continued manageable issuance levels on a net basis. This is accounting for inflows back to investors from principal and interest payments, as well as tenders and buybacks of bonds by companies. While on gross levels, emerging market corporate issuance will surpass US$500bn according to JP Morgan as at January 2021, on a net basis it will be only around US$70bn, what Glavan calls a very manageable amount for a US$2.5trillion asset class. Ongoing inflows into EM corporates will be an additional supporting factor from a technical standpoint.

She comments: “We believe the positive trends underpinning a long-term constructive view on emerging market corporates remains intact. These include improving corporate fundamentals; a strong tailwind from higher commodity prices; and ongoing accommodative monetary policy globally, which we expect to continue.”

Figure 1: External corporate issuance

Source: JP Morgan as at 31 January 2021.

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