The case for emerging-market corporate bonds

The EM corporate bond market offers investors significant opportunities to improve portfolio diversification and boost risk-adjusted returns

With currency crises rumbling on in Turkey and Argentina, and the developing world beginning to feel the full force of rising US interest rates, the headlines regarding emerging markets (EMs) have been notably negative of late.

As such, you might be forgiven for being nervous about the corporate debt of the developing world. But investors who overlook EM corporate bonds could be missing out on opportunities to reduce volatility, achieve greater diversification and improve risk-adjusted returns.

Undoubtedly, EMs currently face some notable challenges. These risks are largely external, namely rising US interest rates, a strengthening US dollar, slowing Chinese economic growth and increasing trade protectionism.

Although such external risks are bound to affect sentiment, there are good reasons to believe that EM corporate bonds, in contrast to their EM sovereign counterparts, should be better equipped to cope with such conditions.

Managing volatility

In the past, EM companies have endured many periods of US dollar strength and have still fared relatively well. The Sino-US trade war will clearly be problematic for certain companies, but it should have limited impact on large swathes of EM corporate-bond issuers.

On the contrary, trade flow redistributions may even be helpful in some cases. Moreover, investors' propensity for indiscriminate overreaction to bad news means that attractive opportunities typically arise whenever markets overshoot.

Mr Adam McCabe, Head of Asian Fixed Income, Aberdeen Standard Investments (Asia) Limited. PHOTO: ABERDEEN STANDARD INVESTMENTS (ASIA) LIMITED

Then there are the risks that are specific to certain markets, including, most notably, the ongoing Turkish and Argentinean crises. These are certainly significant concerns, but they appear largely confined to the countries involved. And in any case, they are more problematic for the sovereign bonds and currencies of these countries. So while caution and defensiveness may be required in some issuers, we feel there should be little reason for generalised panic at present.

Avenues for portfolio diversification

It is also important to note that emerging-market fixed income is not a monolithic bloc. Within the broader asset class, corporate bonds make up the most defensive segment. This year, they have comfortably outperformed other emerging fixed-income markets, including hard-currency and local-currency sovereign bonds as well as frontier bonds. Importantly, the same has been true during every major market sell-off over the past five years.

Beyond their defensive qualities, EM corporate bonds have considerable additional attractions for investors. They constitute a mature asset class which is about $2 trillion[1] in size - larger than the US and European high-yield markets combined. The investable universe in EM debt has grown and broadened in recent decades, and investors can now access this asset class through a wider range of instruments.

This has significantly increased the opportunity set available to fixed-income portfolios. It has also improved the long-term efficient frontier of many investors, enabling them to potentially achieve similar or superior returns with the same or reduced volatility.

Despite the growth of the asset class, from a more structural perspective it is notable that most global investors are currently heavily underweight in the asset class. Bond indices grossly under-represent emerging markets relative to those issuers' importance to the global economy.

For example, EMs are estimated to account for less than 2 per cent of the Bloomberg Global Aggregate (bond) Index - significantly less than EMs' 12 per cent exposure in the MSCI World equity index. [2]

Positive investment returns

Perhaps the biggest argument for EM debt, including EM corporate bonds at present, pertains to valuation. While valuations in other USD-denominated asset classes appear increasingly stretched, EMD looks relatively cheap.

In USD-denominated bonds, the spreads of both Sovereign and Corporate bond issuers offer an attractive premium relative to US corporate bonds. While US investment grade bonds offer limited insulation from rising rates, US high yield corporate bonds have typically benefited from increased allocation during such episodes.

However, with spreads over US Treasuries near their cyclical tights at 324 bps (compared to a 5-year average of 456 bps)[3], US High Yield bonds have less ability to absorb rates moves, making them less appealing in this regard.

In summary, the varied and sizeable EM corporate bond market offers investors significant opportunities to improve portfolio diversification and boost risk-adjusted returns. With the negative news stories regarding individual countries weighing on sentiment toward EMs more broadly in recent months, EM corporate valuations have improved significantly, particularly in countries impacted by localised crises in 2018.

These dislocations have presented an opportunity for investors to increase allocation to EM corporate debt, especially for those who employ a research-orientated, bottom-up approach that allows for positioning in the mispriced EM corporate credits. In contrast, taking an index-investing approach will lead to under-allocation to the most attractively valued offerings in the EM corporates market.

Adam McCabe is Head of Asian Fixed Income, Aberdeen Standard Investments (Asia) Limited.

[1]Source: JP Morgan, June 2017

[2]Source: Bloomberg, MSCI, 2018

[3] Source: Aberdeen Standard Investments, JP Morgan, Bloomberg, September 2018

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