Like most risk assets, the Emerging Markets (EM) corporate bond market has experienced a tough start to 2022. The heavily indebted Chinese property market has shown little sign of bottoming out as contagion spreads through the sector, while incremental easing measures have done little to shore up investor confidence. This was compounded by Russia’s ramping up of military operations in and subsequent invasion of Ukraine, which jolted capital markets and put the brakes on a swift post-pandemic economic recovery.

Despite all the challenges, we retain a positive view on the asset class as whole. This is based on historical precedents and current valuations/yields, as well as fundamentals.

Impacts of geopolitical shocks on EM are typically short-lived

Numerous geopolitical shocks have occurred in EMs since the turn of the 21st century. A useful barometer of such shocks is the price of Credit Default Swaps (CDS), which, in simple terms, provide protection against negative credit events. Research from JP Morgan suggests ⁽¹⁾ that the impact of previous geopolitical shocks on the CDS Index for EMs has been minimal, with prices returning to their pre-shock level within 90 days. Following the current Ukraine conflict, we have seen CDS prices for Russia skyrocketing by +2300% since the beginning of 2022. However, we view the conflict as a manageable risk event for EM companies as a whole, rather than one that changes core views.

Rising US interest rates not necessarily bad for EM corporates

An increasing preoccupation for global markets recently has been the outlook for US policy interest rates. In this regard, there tends to be a widely held assumption that rising US interest rates are self-evidently bad for most risk assets. In fact, closer analysis of the historical data shows that EM corporate debt spreads have often tended to rally once US Federal Reserve (Fed) hikes get underway. For example, as shown below, this was the case in the previous hiking cycles of 2003-06 and 2015-18. Coinciding with tightening spreads, total returns for EM corporates were also positive. For the 3-year period from December 2003 to December 2006, the annualised total return was 7.62%, while from December 2015 to December 2018, the annualised total return was 5.20%.

There are numerous potential explanations for this. For example, it shouldn’t be forgotten that US interest rates (as now) are normally raised to curtail inflation amid strong growth conditions. In the case of EM corporates, it is also worth noting that being hard currency assets, they are protected from potential EM currency weakness that can result from rising US rates. Indeed, higher US rates mean that investors in EM corporates also get higher yields, but still without any local-currency risk.

EM corporate spreads versus US policy rate 2001-2020

Source: Bloomberg Finance L.P, March 2022

Yields and expected income significantly increased

Focusing more closely on recent yield rises, this has been driven by both higher US treasury yields and increased credit spreads. As a result, the starting expected income level for EM corporates has increased very significantly over the past year. EM corporate bonds now yield nearly 6% on a gross basis, up from 4.0% at the end of 2020. The High Yield segment of EM corporates seems especially attractive compared to history, with a yield now above 7.0%, up from 5.8% at end-2020 ⁽²⁾, and offering on average double the spread compensation of US High yield counterparts.

Of course, higher yields in large part reflect compensation for increased risks. This also applies to default risk. Though default rates have generally been trending down since early 2021 we do anticipate elevated numbers in 2022, with Asia and EMEA seeing the highest levels. However it’s worth noting that 99% of distressed debt in Asia now is in the Chinese real estate sector, while in EMEA, defaults are also likely to rise among Russian and Ukrainian credits. Outside of these areas, overall EM corporate fundamentals still look solid.

EM corporate fundamentals remain intact

It is worth highlighting that coming into 2022, companies across EM were in a position of relative strength as many had diversified globally and reduced their foreign exchange susceptibility over the years. Though many fundamental indicators likely peaked in 2021, they remain healthy overall. In particular, it’s worth noting that the earnings weakness of 2019 and 2020 was more than offset by the impressive earnings growth of 2021. ⁽³⁾

EM corporate leverage ratios compare favourably to other European and US credit markets. Indeed, at present, net leverage in EM corporates is 1-2x lower compared to developed market counterparts ⁽⁴⁾. This could change this year as it may not be efficient for companies to remain underleveraged. In our view, should this happen, then even despite rising interest rates, EM corporate interest coverage is likely to remain healthy and unproblematic. Nevertheless, careful credit research and selection will be especially critical in the period ahead.

Putting everything together

EM corporates are contending with a challenging environment of higher inflation, more hawkish central banks, and a war in Europe that is worsening the global economic outlook. Contrary to some quite widely held presumptions, historically, localised geopolitical shocks have had limited lasting impact on EM corporates as whole. Likewise, history does not suggest that rising US rates are necessarily problematic. At the same time, EM corporate fundamentals as a whole remain solid, with a near 6% broad index yield looking attractive for an asset class with no currency risk.

Putting everything together, we feel the positives outweigh the negatives, and that the current short-term noise factors could mask a potentially attractive entry point for long term investors. However, it is worth stressing that in the current environment, selectivity at the geographic, sector and security level will be especially critical going forward.

References

Like most risk assets, the Emerging Markets (EM) corporate bond market has experienced a tough start to 2022. The heavily indebted Chinese property market has shown little sign of bottoming out as contagion spreads through the sector, while incremental easing measures have done little to shore up investor confidence. This was compounded by Russia’s ramping up of military operations in and subsequent invasion of Ukraine, which jolted capital markets and put the brakes on a swift post-pandemic economic recovery.

Despite all the challenges, we retain a positive view on the asset class as whole. This is based on historical precedents and current valuations/yields, as well as fundamentals.

Impacts of geopolitical shocks on EM are typically short-lived

Numerous geopolitical shocks have occurred in EMs since the turn of the 21st century. A useful barometer of such shocks is the price of Credit Default Swaps (CDS), which, in simple terms, provide protection against negative credit events. Research from JP Morgan suggests ⁽¹⁾ that the impact of previous geopolitical shocks on the CDS Index for EMs has been minimal, with prices returning to their pre-shock level within 90 days. Following the current Ukraine conflict, we have seen CDS prices for Russia skyrocketing by +2300% since the beginning of 2022. However, we view the conflict as a manageable risk event for EM companies as a whole, rather than one that changes core views.

Rising US interest rates not necessarily bad for EM corporates

An increasing preoccupation for global markets recently has been the outlook for US policy interest rates. In this regard, there tends to be a widely held assumption that rising US interest rates are self-evidently bad for most risk assets. In fact, closer analysis of the historical data shows that EM corporate debt spreads have often tended to rally once US Federal Reserve (Fed) hikes get underway. For example, as shown below, this was the case in the previous hiking cycles of 2003-06 and 2015-18. Coinciding with tightening spreads, total returns for EM corporates were also positive. For the 3-year period from December 2003 to December 2006, the annualised total return was 7.62%, while from December 2015 to December 2018, the annualised total return was 5.20%.

There are numerous potential explanations for this. For example, it shouldn’t be forgotten that US interest rates (as now) are normally raised to curtail inflation amid strong growth conditions. In the case of EM corporates, it is also worth noting that being hard currency assets, they are protected from potential EM currency weakness that can result from rising US rates. Indeed, higher US rates mean that investors in EM corporates also get higher yields, but still without any local-currency risk.

EM corporate spreads versus US policy rate 2001-2020

Source: Bloomberg Finance L.P, March 2022

Yields and expected income significantly increased

Focusing more closely on recent yield rises, this has been driven by both higher US treasury yields and increased credit spreads. As a result, the starting expected income level for EM corporates has increased very significantly over the past year. EM corporate bonds now yield nearly 6% on a gross basis, up from 4.0% at the end of 2020. The High Yield segment of EM corporates seems especially attractive compared to history, with a yield now above 7.0%, up from 5.8% at end-2020 ⁽²⁾, and offering on average double the spread compensation of US High yield counterparts.

Of course, higher yields in large part reflect compensation for increased risks. This also applies to default risk. Though default rates have generally been trending down since early 2021 we do anticipate elevated numbers in 2022, with Asia and EMEA seeing the highest levels. However it’s worth noting that 99% of distressed debt in Asia now is in the Chinese real estate sector, while in EMEA, defaults are also likely to rise among Russian and Ukrainian credits. Outside of these areas, overall EM corporate fundamentals still look solid.

EM corporate fundamentals remain intact

It is worth highlighting that coming into 2022, companies across EM were in a position of relative strength as many had diversified globally and reduced their foreign exchange susceptibility over the years. Though many fundamental indicators likely peaked in 2021, they remain healthy overall. In particular, it’s worth noting that the earnings weakness of 2019 and 2020 was more than offset by the impressive earnings growth of 2021. ⁽³⁾

EM corporate leverage ratios compare favourably to other European and US credit markets. Indeed, at present, net leverage in EM corporates is 1-2x lower compared to developed market counterparts ⁽⁴⁾. This could change this year as it may not be efficient for companies to remain underleveraged. In our view, should this happen, then even despite rising interest rates, EM corporate interest coverage is likely to remain healthy and unproblematic. Nevertheless, careful credit research and selection will be especially critical in the period ahead.

Putting everything together

EM corporates are contending with a challenging environment of higher inflation, more hawkish central banks, and a war in Europe that is worsening the global economic outlook. Contrary to some quite widely held presumptions, historically, localised geopolitical shocks have had limited lasting impact on EM corporates as whole. Likewise, history does not suggest that rising US rates are necessarily problematic. At the same time, EM corporate fundamentals as a whole remain solid, with a near 6% broad index yield looking attractive for an asset class with no currency risk.

Putting everything together, we feel the positives outweigh the negatives, and that the current short-term noise factors could mask a potentially attractive entry point for long term investors. However, it is worth stressing that in the current environment, selectivity at the geographic, sector and security level will be especially critical going forward.

References