Market dislocations offering value and event-driven opportunities
The emerging market corporate index (CEMBI Broad Diversified) spreads were 300 basis points before the crisis, then widening to nearly 600 bps at the height of the crisis. To date, they have tightened to below 500 bps. All in all, the spread widened about 300 bps then tightening around 130 bps from 23 March to date.
Looking at investment grade and high yield separately from the widest point in the crisis to date: EM corporate investment grade has tightened 90 bps (vs. 180 bps US investment grade) and EM corporate high yield has tightened 280 bps (vs. 430 bps US high yield)
Therefore, EM is still lagging developed markets since the start of the rebound, but it is catching up. EM high yield has tightened by 60 bps more than US high yield since mid-April but has recently given up a little vs US high yield. In our view, this is probably due (amongst others) to the rebound in oil prices, supportive of US HY.
In May, the benchmark has delivered 3.5% performance to date (in USD) with high yield outperforming investment grade (5% vs 2.5%).
From a regional point of view, Africa appears to be the standout performer for two months running with 6% to date. The laggards are high-quality Asia and the Middle East at 2.5%. From a sector point of view, metals & mining as well as oil & gas unsurprisingly leading the pack, while transport is still struggling.
There is not that much high-yield issuance yet, because prices remain low (spreads high), so they remain unattractive issuing for many issuers, but there are signs of improvement. For example, this week, the lower-rated (BB-) Petrobras came to market, with an attractive initial price guidance.
In the secondary market, with the recent and strong rally, it can even be hard to buy securities as people begin to see that there is value in EM corporates. While liquidity is improved, price movements can still be substantial, so when a trade is done, it can move the price significantly. For example, earlier this week bonds of the Brazilian construction company Andrade Gutierrez were trading in the mid-50s then jumped to mid-60s. This kind of gapping in prices can be seen in many EM corporates, which to us expresses how inefficient the markets have been recently.
In Brazilian corporates, we find lots of opportunities, one of the reasons is that it is a market with a wide variety of industries and issuers to choose from. For example, we have added some Petrobras, which we see as a good company despite its low rating. We’ve also taken a position in Embraer in anticipation of a rebound in aviation, as well as holding the Andrade position.
Airlines have been hard hit by the corona crisis and the industry’s outlook remains unsure. However, currently we find some airline companies attractive, with the view that the market is now discounting the fundamentals due to restructurings going on in the industry as a whole. With these specific cases, we remain prudent and do not take large positions.
In our view, EM corporate bonds is the ultimate inefficient asset class. An inefficient asset class will exhibit erratic pricing behavior during times of market stress and in the early stages of a recovery. We believe we are now in the early stages of a recovery. Overall, we believe that EM corporate bonds corrected beyond what could reasonably be explained by the deteriorating fundamental outlook. As we go forward, we expect this discrepancy between corporate fundamentals and market price to begin to normalize.
We believe that, as many investors still prefer it, investment grade is becoming expensive. For us, the opportunities now can be found in the high-yield space and some of the beaten-up names, provided of course that investors adhere to diversification and careful credit analysis. In our view, forced selling due to downgrades has pushed prices low, revealing pockets of value.
It’s important to remember that there will be restructuring, however, restructuring is not the same as bankruptcy or a recovery rate of zero. Therefore, in this area, there can be significant gains to be made as nervous investors push prices below fundamentals.
On a beta level, spreads have tightened but remain elevated and still lagging developed markets despite catching up since mid-April. This leads us to believe that there is still room for EM corporates to continue to catch up with developed market corporates as investors begin to come back to the asset class.
On an alpha level, we still see plenty of dislocations in the market on both the value and event-driven sides, which allows us to stock up on plenty of excess spread/current yield in the portfolio, but with a lower average rating to the benchmark (end of April).
- The portfolio still has above 15% spread, a B+ average rating based on figures from a week ago, and a 9% current yield in USD. In our view, this should provide a buffer in bouts of volatility.
Our strategy remains the same as always: We’re not here to buy the market, we’re here to buy the perceived mispricings in the market and this is where our bond picking focus is.
For further information on performance and investment considerations regarding funds included in this Insight, please click on the respective "Related Funds" below.