When it comes to emerging-market (EM) bonds, clients often ask us if they’re being adequately compensated for their risk. It’s a fair question, but answering it isn’t as easy as many people think.
We certainly think investors should be paid for taking EM risk. But figuring out if they’re being compensated is about more than bond yields and credit ratings. It requires a deep dive into the business profiles of individual companies.
What do we mean? Simply that in today’s interconnected world, EM risk isn’t confined to companies based in developing countries.
EM Risk Is Often Mispriced
Of course, investing in emerging markets is broadly riskier than sticking to markets in the developed world. Corporate governance tends to be weaker, with fewer protections for creditors and shareholders, politicians and policymakers more unpredictable, and currency fluctuations more frequent.
These EM hazards are why investors can collect a premium for taking on the risk. For instance, a basket of BBB-rated EM corporate bonds will offer a higher risk premium than does a basket of comparably rated securities from companies based in advanced economies.
But EM risk can lurk in a wide variety of individual bonds, and it often doesn’t matter whether the borrower hails from Shanghai, São Paulo or Seattle. What’s more, the market often misprices that risk. A broad, top-down approach that groups credits into developed-market (DM) and EM buckets, and assumes the latter are always more risky, may not pick up on that distinction.
A Tale of Two Bonds
Let’s think about it this way: Take two bonds. The first is from Grupo Bimbo, a Mexican food company that does around half of its business in the developed world. The second is from Mead Johnson Nutrition, a child nutrition company from the US, with a big footprint in emerging markets. Which one has more EM risk?
It may turn out to be the second one—even though this bond might be underpaying investors for its EM risk.
There are plenty of DM companies with exposure to emerging markets and the risk that comes with it. Apple, for example, sources from and sells to emerging markets. Wal-Mart Stores and Citigroup, meanwhile, got caught up in corruption scandals in Mexico.
At the same time, many EM companies have become more global by moving into developed markets. But the companies’ ratings still depend on where those companies are domiciled.
Hitting the Sovereign Ceiling
These ratings are partly the result of the sovereign ceiling rule, which holds that private companies’ ratings cannot be too much higher than the government’s.
Since ratings agencies generally assign lower ratings to companies in developing countries, firms with home bases in Malaysia, Poland or Peru almost always carry lower ratings than do comparable firms in Japan, Germany or the US—even if the companies’ business profiles suggest that they should be on equal footing.
Take that Mexican food company scenario. Half of the company’s operations may be in the US and Canada. But because the firm is based in Mexico, its maximum possible rating would be a notch or two above the government’s. Move the company across the border to Texas, though, and the rating would shoot up.
In this case, investors who focus on ratings and how a bond is trading might conclude that the risk isn’t worth the reward. Those who drill down more deeply would find that they’re getting paid more than they should be, since the firm’s level of risk is based on its country of origin, not its business profile.
Think Globally and Take a Case-by-Case Approach
Of course, even well-run companies in some EM countries may be subject to risks that a firm in the developed world wouldn’t face. These hazards include political turmoil, corruption and nationalization, to name just a few.
These potential perils underscore the importance of looking at emerging markets through a global lens and understanding the varying political and economic dynamics at play throughout the world.
But these risks also show why it’s so critical to invest on a company-by-company basis and take a deep dive into each individual bond, regardless of the issuer’s home country. Investors who take this practice to heart may be surprised by what they find.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.