Emerging Market Corporate Bonds Outlook and Portfolio Positioning

Market Update

• We see a strong improvement in markets after the March crisis. The IMF and other international institutions providing support has resulted in improved liquidity and primary markets opening again, first for the higher quality sovereigns and quasi sovereigns (Petronas for example), later we saw high yield issuers, like Bahrain and this week we see many new issues coming to the market.
• Overall, EM corporate spread widening was less than in the EM sovereign space, up to 600 bps towards the end of March from start of year lows at 300 bps, now we’re back to around 500 bps, so around 100 bps recovery/tightening from recent wides.
• Investment grade corporates have tightened around 70 bps and high yield around 220 bps. As a comparison, US investment grade tightened 160 bps and US high yield around 340 bps. Therefore, we can see that EM corporates still lag US corporates in the speed of recovery.
• During the last two weeks, EM high yield corporates have started to catch up with their US market peers by tightening 100 bps more.
• In April, Africa was the top performer (Ghana up over 60%!), high-quality Asia was the laggard, but still positive. However, this should be viewed in the context that Asia was clearly the star performing region in March.

Positioning

• - We have three specific things we are focusing on:
  • Diversification is a key topic for us. We have focused on enhancing this further. As a reminder, for high conviction trades we generally take up to a 3% weighting within the portfolio, now our largest single position is just above 2%. As there are so many more opportunities available in the market than before March, it’s easier and prudent to diversify, in our view. We also have some positions in the portfolio that are close to 2%, but their increased weight is more a result of recent price performance of the bonds.
  • Liquidity. Even though we now have reduced cash in the portfolio, we now have positions that we assess as being more liquid than before. This means the portfolio now holds more higher quality investment grade names. We have also sold less liquid positions when we have found opportunities to do so.
  • Credit Quality. We have taken steps to improve the overall credit quality of the portfolio. This may not be so evident at first glance, as the market, in general, has had so many downgrades. By buying higher quality investment grade names (as mentioned above) where we feel that there is still value to be found, we feel that the credit quality of the portfolio is now stronger. However, it will take time before the upside materializes because firms have to reorganize themselves (deleverage, sell assets, etc.). When a crisis hits, it’s not easy to sell assets overnight. We do continue to see evidence of forced sellers in certain segments of the market. We also try to exploit mispricings from such sellers. The current strategy can thus be seen as a barbell, with a focus on the more liquid, high-quality end of the market and on the lower quality, more inefficient, end of the market.
• The current yield (coupon/price) of the portfolio is slightly below 10% in USD. Yield-to-maturity (YTM) is now around 20% in USD, having come down somewhat during the past month as performance has improved. Note that we find the YTM metric as somewhat misleading, it assumes that bonds go to par linearly. However, we don’t buy bonds to hold them to maturity. We buy them because we think there is price upside. For example, at times we may buy bonds that will go to recovery, but only if we see them trading at a clear discount to their recovery value.

Outlook

• The market is now more liquid than last month and the primary market is reopening. For example, in Asia we see high yield names coming back. However, it does not mean all is liquid and efficient. We still see moderate outflows, but the situation is improving.
• It remains important how quickly economies recover. This is dependent on, amongst others, Western economies opening up, oil price recovery, and company results.
• We’re looking at how companies will adjust to the current environment. Although it’s difficult to predict, we do expect improvements.
• Recovery in DM has been stronger but EM is becoming relatively more attractive than DM, in our view, which should bring flows and allow prices to recover.
• We expect a slow and, at times, unsteady recovery. However, higher spreads will give more income for longer, so as bond investors, we prefer to wait and see and are comfortable with a slower and longer recovery.