Has Come of Age
While investors have flocked to emerging-market government bonds in recent years, some still perceive emerging-market corporate bonds as an immature asset class. Shamaila Khan, who manages global credit portfolios, questions some assumptions about emerging credit.
Emerging Corporate Bond Market Has Matured
Conversations we’ve had in the marketplace suggest that many investors are thinking about moving into emerging-market (EM) credit, but they’re not sure if the time is right. The most common concerns that they cite are risk, volatility, limited market size and lack of diversification. We think the market has now evolved to the point where all four of these concerns have been addressed.
First, we’d argue that EM corporates aren’t necessarily any riskier than emerging government bonds. Based purely on credit ratings, they’re actually less risky.
The average rating for corporates is BBB, compared with BBB- for sovereigns (that’s the J.P. Morgan CEMBI Broad Diversified versus the J.P. Morgan EMBI Global.) 70% of corporate issuers are investment grade-rated and more than 90% are domiciled in investment grade-rated countries.
That said, history is full of cautionary tales like the bond issued in 2008 by Brazilian beef producer Arantes Alimentos. Investors were attracted by the yield of more than 10%, but didn’t see a single coupon payment. The company filed bankruptcy and, by the end of last year, legal resolution was still pending and the bonds were trading below 5 cents in the dollar.
As Arantes illustrates, successful EM credit investing depends on avoiding the losers as much as on picking the winners. And it’s important to recognize that, while the levels of risk for government and corporate bonds may be comparable, the drivers of risk may be very different. Investors need a sound understanding of the risks at the company and industry levels as well as a view on sovereign risk.
Second, depending on which index you look at, the volatility of EM corporates is close to, or lower than, that of sovereigns. Looking at the J.P. Morgan indices mentioned above, over the past decade EM credit has had an annualized volatility of about 8.8%, compared with about 9.5% for sovereigns. Investment-grade corporate volatility was closer to 7.4%. (Note that lower volatility was accompanied by somewhat lower returns. Between February 2002 and March 2012 the Sharpe ratios—return per unit of risk—were 0.96 for EM credit, 1.17 for sovereigns and 1.03 for investment-grade credit.)
We believe EM credit volatility is on a downward trend. This is at least partly due to the nature of investment flows. In the early days of EM credit investing, a lot of new entrants didn’t understand the markets well, underestimated the complexity of the credit analysis required and were quicker to panic when market conditions became difficult. For others, EM credit was a bet they were taking outside their benchmark, so they were quicker to close out those positions if they weren’t performing. Today, investors have a better understanding of the market, as asset-management companies are investing more in EM credit research. And more EM funds are being launched that include EM credit in their benchmarks, which implies that money in corporates is likely to be stickier than it was in the past.
Third, the EM credit market is now big enough to take seriously. At about $940 billion, it’s comparable to the US high-yield market (around $1,060 billion) and significantly bigger than the stock of EM sovereign debt (around $450 billion).
Issuance has been on a strong upward trend. The stock of hard-currency emerging-market corporate debt has almost trebled since 2005. Since 2006, corporates have issued at least twice as much as sovereigns every year except 2008.
Finally, we think EM credit offers a good degree of diversification. The opportunity set spans 345 issuers across 38 countries. (This, as we’ve argued in the past, compares very favorably with the sovereign-debt opportunity.)
No single issuer accounts for more than about 3% of the index and no country represents more than about 7%. As shown in the pie charts below, the opportunity set is reasonably well diversified by region, and a number of industry sectors are represented.
In short, if investors are comfortable with emerging-market sovereigns, then we think there’s just as much reason to consider corporates. We think credit is going to be the best way to capture the EM opportunity in the coming years.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Shamaila Khan is a Portfolio Manager of Global Credit, both at AllianceBernstein.