1. Attractive valuations

In particular, and despite the strong rally of November, yields for EM corporate bonds are at historically attractive levels. The end-November index yield of almost 7.80% is up from 4.58% at the end of 2021, and far above the long term 20-year average of 6.13% ⁽¹⁾. Higher yields have been driven mostly by surging US treasury yields, although spread compensation has picked up – by 90 basis points for the broader index relative to end-2021.

All in all, the we think current yields provide more than enough compensation relative to the risks at present. This is especially so given the fundamental and technical backdrop.

2. Modest leverage compared to developed markets

In terms of fundamentals, the weaker global growth environment is bound to have a negative impact in terms of EM corporate earnings. However, excluding the well-documented impact of Russia, Ukraine and China, JP Morgan’s default rate predictions for 2023 are not too dissimilar from US or Euro High Yield. A big driver of this is corporate balance sheets, which as a whole are in good shape, with comparatively modest debt burdens due to effective liability management in recent years. Indeed, EM corporate leverage relative to similarly rated developed market companies is around one to two times lower in aggregate. This should provide some comfort in an environment of sharply higher borrowing and refinancing costs.

Increased EM corporate tender activity in the last six months also indicates leverage reduction and balance sheets with comfortable liquidity.

3. Supportive supply-side picture

On the technical side, the supply picture is highly supportive. With the primary market now subdued, JP Morgan expects net financing to be firmly in the red to the tune of USD218 billion by end-2022 ⁽²⁾. As such, this will be the first time the EM corporate bond asset class has shrunk in over a decade. This is being driven by the rise in the risk free rate and issuers increasingly looking to alternative sources of funding such as the local bond markets or bank loans. All else equal, reduced bond supply should act as a downforce on yields, supporting returns.

4. Structural features

Within the broader EM debt asset class and global fixed income asset class, EM corporate bonds tend to have relatively lower duration. For example at end-November, index duration of 4.2 was considerably lower than the 6.8 for EM sovereigns and 6.3 for global investment grade corporates ⁽³⁾. This is important because lower duration means lower sensitivity to rising interest rates, which is very much a key risk factor at present.

Another important structural feature to bear in mind is that EM corporate credit ratings are effectively constrained by the sovereign rating of the country in which they are based. Normally, there's a cap of one or two notches above the sovereign rating. While EM corporates rating trends have been net negative in recent years, this action has been driven more so by sovereign rating changes rather than standalone rating changes as a result of corporate fundamentals. Sovereign-driven downgrades can result in potential mispricing opportunities since the track record and credit standing of corporates can sometimes compare favourably to their country of domicile.

Final thoughts - the importance of selectivity

While we believe the overall risk/reward balance is good for the EM corporate bond asset class, we also think the current macro environment strongly reinforces the need for investing selectivity. This is because effective credit selection becomes even more important in tighter financial conditions and weaker growth environments. A key concern for investors should be avoiding potential ‘value traps’ – those cases where higher bond yields are actually not compensating for the totality of risks.

References