Conventional wisdom among institutional investors is that emerging market debt (EMD) markets should be viewed through the lens of the sovereign segment of the asset class, and that sovereigns should be considered the core of EMD. Given the history of what for more than two decades has been an asset class primarily ruled by sovereign debt, this is not surprising, particularly as sovereign-related risks tend to dominate the headlines. But the evolution of the EMD market means that it is time to look at it in a different way.
Looking back at EM debt market development, it was after the 1982 Latin American debt crisis that US commercial banks began to trade the area's non-performing sovereign loans, creating a secondary market for the debt. Trading increased throughout the 1980s, but while the market's liquidity improved, the ability of these emerging nations to access international financing did not, leading to the economic stagnation that made the 1980s a "lost decade" for Latin America.
It was into this void that US Treasury Secretary Nicholas Brady introduced a plan to address the so-called LDC (Less-Developed-Country) Debt Crisis in 1989. The Brady plan sought to allay debtor and creditor concerns by granting debt relief in exchange for greater assurances of repayment and economic reform. Under the plan, debt holders would be able to exchange their loans for either fixed or floating rate 30-year bonds denominated in US dollars, with principal secured by US Treasuries. This created more tradeable securities —known as "Brady bonds" — allowing creditors to diversify their risk and spawned the EM debt asset class we know today.
The expanding breadth of the market alongside robust demand signaled the need for a dedicated performance measure, which was met with the creation of the J.P. Morgan Emerging Market Bond Index (EMBI) in 1992. Consisting solely of Brady bonds, it was replaced by the EMBI Plus Index in 1995, which included the burgeoning Eurobond market.
For 12 years, EMBI indices were the only option for investors into USD EM debt, as it wasn't until 2007 that J.P Morgan launched a non-sovereign index (the Corporate Emerging Market Bond Index, or CEMBI). It is therefore not surprising that assets managed against external sovereign indices are five times greater than those managed against corporate indices — US$440 billion versus US$85 billion. Over the past year, however, the volume of flows into EM markets has switched, as US$6.5 billion flowed into strategies managed against corporate indices compared to US$980 million for sovereign. (Source: eVestment Alliance as of 30 September 2019)
By 2007 and the launch of the CEMBI, the market had grown to over US$500 billion, yet it was still only half the size of the external sovereign market and still viewed as an add-on to core EM debt portfolios. Today, the EM corporate debt market has grown to over US$2.3 trillion, more than twice the size of the external sovereign market and greater than the US high yield market. This shift represents a compelling argument for the corporate market to replace the external sovereign market as the benchmark of choice for "core" EM debt allocations.
Source: J.P. Morgan and PineBridge Investments as of 31 December 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid only as of the date indicated, and are subject to change.
The expansion of the EM corporate debt market has been broad-based. In 2007, the CEMBI Broad Diversified Index consisted of 32 countries with the top four representing nearly half of the index. Today, the index comprises 55 countries and the current top four represent less than one quarter of the index. The breadth of the corporate market also supports active management and diversification as 14 of those 56countries feature securities issued by more than 20 distinct issuers. (Source: J.P. Morgan and PineBridge Investments as of 31 December 2019)
Risk is a certainly a factor to consider but, examining the difference between EM corporate debt versus sovereign risk over the past five years, EM corporate debt has delivered the best risk adjusted returns among all major fixed income markets.
EM Corporate Debt Has Outperformed EM Sovereign Debt
Source: JPMorgan and PineBridge Investments as of 31 December 2019. Corporate debt is JPMorgan CEMBI Broad Diversified, Sovereign debt is JPMorgan EMBI Global Diversified. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Past performance is not indicative of future results. Any views represent opinion of the manager and are subject to change.
Risk, and the sources of risk, will be of focus in 2020 as investors look for opportunities to generate income in a low yield environment. Here, we find further support for the corporate market, as the corporate market offers the same yield to maturity (roughly 5%) as the sovereign market, albeit with roughly 3 years' less duration (4.4 years, vs. 7.5 years).
Fundamentals also support the view that corporates will get their place in the spotlight in 2020, as EM corporates typically carry less leverage than similarly rated DM corporates, and have historically defaulted less often than their DM counterparts. Finally, while EM Corporate new issuance remains robust, strong local demand and an increase in yield-hungry global demand create a favorable technical backdrop as well. After years of serving as an off-benchmark allocation for many EM investors, we believe that it is time for investors to consider adopting a strategy benchmarked to corporate debt, with allowance for off-benchmark positions in sovereign debt, rather than the more traditional route of using a sovereign benchmark and adding off-index corporates.
Steve Cook, co-head, Emerging Markets Fixed Income at PineBridge Investments