An increasingly diversified and liquid asset class

EM corporate bonds are well diversified across regions, with an average IG credit rating of BBB. Since 2010, the asset class has grown 250% to over US$2.5 trillion, and is now larger than the EM sovereigns and US high yield (HY) markets.  

Source: J.P. Morgan, Bond Radar, Bloomberg Finance L.P, 31 July 2024.

The asset class has also become increasingly diversified by country, region, sector and market capitalisation. By region, Asia remains the largest at 42% of the JPM CEMBI Broad Diversified Index. However, the proportion of debt issued by companies from the Middle East & Africa has risen from 11% in 2013 to nearly 20% in 2023. There are 59 countries in the Index, including several market-leading companies from frontier economies, such as Georgia, Guatemala and Zambia.

The Index is also well diversified by country, with China the largest weighting with just under 7% of the Index, compared to a weight of around 24% in the MSCI EM (equity) Index. Such a rich and diverse asset class presents potential opportunities for active investors. However, access to sufficient research resources and proven investing skill can be particularly important for finding value among smaller EM corporate debt issuers.

Supportive technical factors a tailwind for performance

In recent years, a supportive technical factor has been the extending of maturities by EM corporates, thus reducing refinancing risks. In a higher US interest-rate environment, primary issuance in the US dollar (USD) eurobond market has unsurprisingly been subdued. Instead, EM companies have pivoted to alternative sources of financing, such as local markets, domestic banks and development finance institutions. These alternative funding sources provide credit protection for EM companies and help reduce rollover and default risks.

Negative net financing in USD eurobonds, where primary issuance is less than debt that has matured, has supported demand and supply dynamics. This should continue to provide a tailwind for the market and is one the reasons why we are overweight corporates in Latin America.

Source: J.P. Morgan, Bond Radar, Bloomberg Finance L.P, 31 July 2024.

Underlying fundamentals for EM Corporates remain robust

EM corporate bond fundamentals are generally favourable. In the BB-rated space (i.e., HY), EM corporates have net leverage of 2.3x, which compares favourably to 3.6x in US HY and 4.5x in European HY. Typically, lower leverage should equate to tighter spreads. However, this does not apply in this case. For BB-rated EM corporates, the current Z-spread (the additional yield over US Treasury yields) is 245 basis points (bps). For BB-rated EM corporates, as at end-August 2024, the Z-spread is 328bps, versus 295bps for BB-rated names in the US, and 310bps for BB-rated names in Europe [1].

Given EM corporates’ combination of higher spreads and better fundamentals (lower leverage and higher cash reserves), our preferred metric for comparing the asset class to US credit is ‘spread per turn of net leverage’. The charts below shows that investors in EM corporates are currently compensated with more spread relative to the amount of leverage versus US companies.

Source: BofA Global Research, 30 June 2024.

Of course, there’s an argument that macroeconomic and political risks are generally higher in EMs than in the US. Yet, this is not reflected in higher default rates, at least. In 2024 so far, EM corporate bonds have a 0.8% default rate, versus 0.6% for both US and European HY. And as shown in the chart below, EM corporates’ historic default rates are not too dissimilar to those of US and European HY. Over the remainder of 2024 and into 2025, we  expect that rate-cutting cycles should help to contain default risks.

Source: JP Morgan, BofA, July 2024.

EM corporates – an attractive trade over the past decade

As highlighted below, on a risk-return basis (i.e. Sharpe Ratio), over the long run, EM corporate bonds compare favourably to most other global bond market segments.

Table 1: Selected global bond market Sharpe Ratios

Source: JP Morgan, abrdn, June 2024 

Meanwhile, the asset class has relatively low duration, which can reduce interest-rate risk.

EM corporate bonds have historically offered some defensive benefits. For example, drawdowns were relatively lower than other EM debt segments during major risk-off episodes, such as the ‘taper tantrum’, pandemic and Russia’s invasion of Ukraine.

The JPM Index for EM corporate bonds currently yields more than 6.5% (in USD). This is above the10-year average of 5.7% and provides some potential downside cushioning from adverse price movements. When combined with EM corporates’ sound fundamentals and supportive technical factors, it's perhaps not surprising then that the asset class is gaining popularity with institutional investors. This includes, insurance companies, which traditionally focus much more on developed market credit exposure.

Putting everything together, where are we today?

Confidence is returning to the USD primary market. EM corporate bond issuance in the first half of 2024 reached its highest level in three years. In recent months, spreads have also narrowed and are approaching levels not seen in a long time, particularly in IG EM corporate bonds.

However, the absolute yield in excess of 6.5% continues to look attractive relative to history. Considering the strong underlying fundamentals and supportive market technical tailwinds, we think EM corporate bonds can continue to deliver attractive total returns, including on a risk-adjusted basis.

Our Emerging Markets Monthly Insights are brought to you by our Equities and Fixed Income investment teams and their emerging markets experts. This is a core strategy within our public-markets offerings.