Renewed investment inflows and rising performance are the dominant early 2017 trends in emerging markets (EM). This represents a dramatic turnaround from the outflows, volatility, and protectionist fears of the post-US election period. We believe investors should look beyond the headlines and toward the long term when it comes to investing across EM – here are four reasons we are positive on EM’s oft-overlooked corporate debt segment.
1. The growth of EM corporate debt is a story of rising investor confidence. Emerging market debt (EMD) today is an investment universe of more than $3.5trn, having grown into a major asset class spanning hard and soft currencies, as well as the government and private sectors. Corporate debt, most of which is dollar-denominated, now accounts for almost a quarter of this universe.
We would attribute EM corporate debt’s rise (see image below) to robust investor demand, rapid long-term EM economic growth, and increasing integration into global capital markets. To us, the fact that demand has kept pace with brisk supply is a sign of investor confidence in the quality of EM corporate debt markets.
2. The yield premium persists. EM corporate debt has offered higher yield over similarly rated developed market (DM) corporates. Higher yields are in part a reflection of the higher risk premium investors typically require when investing in EM.
But we think investor perception of risk in emerging markets is changing. Corporate governance is improving in private markets and macro policy across the EM universe is becoming more orthodox. Meanwhile, events in Europe and the US have demonstrated that political risk exists in the developed world, too.
At the company level, we see improving fundamentals, as reflected by trends of consolidating leverage and conservative capital expenditure, both of which are positive for credit quality. From a technical point of view, we see a supportive supply outlook in 2017, with relatively subdued net issuance for EM corporates, with the likely exception of China, where we continue to observe a buildup in corporate sector leverage.
3. Security selection matters in emerging market debt. The EM corporate universe includes over 540 issuers across more than 50 countries. We see opportunities for skilled security selection arising more frequently when compared to developed markets, in part because the EM corporate sector receives less coverage by research analysts.
We believe rigorous fundamental research can help identify idiosyncratic opportunities where return potential adequately compensates for the associated risk, while foregoing areas of undue credit risk. We also see a need to examine macro and credit conditions in individual EM countries. EM is no monolithic bloc.
We think active managers can add alpha by understanding each country’s position in the economic cycle and identifying sovereign tail risks which may impact the corporate sector.
4. EM corporate debt can help diversify existing corporate credit and/or traditional fixed income allocations, or be used as a complement for existing EM investments. Credit cycles across emerging markets are at varying stages and offer a wide spectrum of opportunities.
By contrast, the US credit cycle is at a later stage. We believe EM corporate debt offers investors the opportunity to lend to companies that may benefit from an expanding middle class, which could be one means of diversifying DM corporate credit allocations.
EM corporate debt can also be used as a diversifier due to low historical correlations with traditional fixed income (for instance the Bloomberg Barclays Aggregate Bond index). When compared with EM sovereign debt, the sector typically has a lower duration but higher credit quality, and in our view can serve as an attractive extension to existing EM allocations.
Angus Bell is portfolio manager, Global Fixed Income at Goldman Sachs Asset Management