Fixed income 2021
Unfix your thinking.
Emerging markets corporate bonds are a relatively new asset class and at the same time emerging markets often make for spectacular news headlines. There is always something happening somewhere in the world. Both observations mean that emerging markets corporate bonds are still an exotic asset class for many investors and few investors consider the asset class when optimizing their portfolios.
This is shown in chart 1, which compares the total market capitalization of the benchmarks of EM hard-currency sovereigns and EM hard-currency corporates (black bar) and the size of the Morningstar peer group of the category in question (blue bar). The chart demonstrates how few investors specialize in them. Note that many corporate bonds are not included in benchmarks, so the total size of the asset class when including both benchmark and non-benchmark bonds is over 2 trillion US dollars.
Because the asset class is still exotic for many investors, emerging market corporate bonds offer relatively high spreads for the risks involved, especially when one takes into account the diversification benefits on offer in the asset class. In a low-rate environment, the level of spread (the yield on offer above a comparable government bond of a similar maturity) of any given bond gains in importance, particularly for income- and return-oriented investors. In our view, EM corporate bonds are currently in a sweet spot. They offer higher yield and therefore more income than their developed market peers and have the potential for capital appreciation as credit quality improves.
Not only is the asset class lacking a specialized investor base, many investors in the asset class are guided by both behavioral and regulatory restrictions which lead to market segmentation and price overreactions that can be exploited by active managers. This is why we believe this asset class is an active manager’s paradise unlike any other asset class.
Companies can go bankrupt and therefore, many investors believe that EM corporate bonds are very risky. As a result they may feel that the best way to invest in emerging markets is either through sovereign bonds, as they are perceived to be less risky, or through equities as they allow an investor to capture price upside (or beta). However, things are not that straightforward in emerging markets. There are a number of reasons why the EM corporate bond asset class is both the least risky segment in EM and at the same time offers significant price upside. Indeed, an active manager’s paradise.
First of all, the sovereign and corporate asset classes are complementary in many ways as the composition of the benchmark is different. The sovereign index has more countries, including many frontier countries that typically do not have many companies with international bonds. The corporate benchmark, on the other hand, is more geared towards companies in countries with better credit quality. This makes the credit risk lower for the corporate index than for the sovereign index.
Secondly, because sovereign bonds are less likely to restructure, sovereigns, especially those offering better credit quality can attract longer-term financing and issue longer-dated securities. Thus lower credit risk is counterbalanced by a higher interest rate or duration risk in the sovereign index. Investors are therefore wise to consider whether they prefer credit risk or interest rate risk. On the other hand, the duration aspect is another dimension along which sovereign and corporate indices complement each other.
Third, while it is true that at the security level, emerging market corporate bonds can display high volatility, there is also the saying that diversification is the only free lunch. We disagree with the saying, but it is true that at over two-and-a-half trillion US dollars in size (including out of benchmark bonds), emerging market corporate bonds offer broad diversification. The diversification is not only across countries and industries but also across the types of companies. On one side, there are sovereign related entities that fulfill policy goals and are not necessarily driven by a profit motive. On the other side, there are private companies.
Due to the generally higher growth rates in EM, many private companies are fast-growing and have a lot of valuable investment opportunities. For company owners, the bond market can provide an attractive funding source without diluting their control. Furthermore, since bondholders are paid before shareholders, the cost of financing associated with bonds is lower for companies than financing through equity. Bondholders realize price upside if the credit quality of the companies improves and spreads tighten.
However, there are of course also periods of higher volatility and at the issuer level corporate bonds can be risky. These events are the ideal fuel for headlines that result in less sophisticated investors running for the exit and prices diverging from fundamentals. These are moments of great opportunity for active managers to display credit selection skills and separate the good companies from the bad. When the volatility subsides and prices converge to fundamentals, these managers are rewarded with significant price upside.
In sum, we believe the emerging market corporate bond market is the least risky emerging markets asset class in aggregate, but the volatility of the underlying securities allows active managers to realize price upside on top of the higher carry.
“Am I being compensated for the risk I take?” is key question every investor wants answered. For this, a commonly used indicator of risk-adjusted returns is the Sharpe ratio. The higher the Sharpe ratio, the more excess returns investors receive for the risk they take. EM corporate bonds can offer comparable, and at times better, risk-adjusted returns than other asset classes. What you should also note is that in recent years, emerging-market corporate bonds show a significant increase in Sharpe ratio, unlike every other fixed-income sector.
Since yields in many fixed-income segments are submerged in negative territory and markets are still coming to terms with the pandemic-induced drawdowns of 2020, now is an opportune time to reassess how EM corporate bonds behave and what they can offer investors. Rather than considering emerging-market corporates as high-risk assets, they should be viewed as an essential part of any diversified, income-seeking or performance-focused portfolio.
In an investment landscape starved of income, emerging market corporate bonds remain an area, which can potentially offer investors higher yields than developed markets with, in our view, a reasonable level of risk. Improving credit quality (typically associated with high growth) results in capital appreciation, while coupons provide a rare source of income in a low-rate world. At a time when rising rates are a major concern for many investors, the lower interest-rate sensitivity of the asset class provides an additional benefit.
Emerging market bonds offer an elevated level of spreads and it’s for the individual investor to assess if they feel the potential remuneration on offer is sufficient. This will depend on your personal risk tolerance and the ability of your chosen investment manager to differentiate good risks from bad risks. Investors who can successfully differentiate between the two are in a position to help generate alpha. We believe that investors should not shun the volatility associated with price overreactions. On the contrary, they should embrace it and take the opportunity to generate income uncorrelated with the broader market by working with experts in credit selection. By taking an active and bottom-up approach, investors can unlock the value inherent in emerging markets corporate bonds, allowing a significant boost to portfolio yields and thus income.