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Fixed-Income Insights

The days of emerging-market corporate bonds being thought of as a niche asset class are, in our view, behind us.

Emerging economies have played an increasingly large role in global GDP growth. In fact, global policy makers now require Brazil, India, and China, among others, to have a seat at the table when discussing changes to the global financial architecture. This is attributable to the positive evolution of the developing world during the last 20-plus years. Many developing countries have matured significantly, moving from pegged exchange rates to floating-exchange rates, and establishing central banks that are independent of their governments and now focus on managing domestic interest, inflation, and growth rates. In addition, many have implemented fiscal discipline, accumulated significant foreign reserves, and developed functional local capital markets. In fact, economic stabilization and maturation have allowed emerging issuers to be among the first to access the capital markets coming out of the global financial crisis.

More specifically, emerging market (EM) corporate bonds allow investors to tap into the next stage of EM economic growth and development by investing in the debt of corporations that appear best positioned to take advantage of positive secular trends. For example, the resources required to support the growth in India and China, in terms of residential and commercial real estate investment, is staggering, as China adds the building-equivalent of Manhattan every two years, and India adds the equivalent of Chicago every year. Urbanization in these regions necessitate the development and expansion of infrastructure in terms of telecommunications, banking, homebuilding, power plants, railroads, port facilities, and water and electric utilities. The resources needed include steel, iron ore, copper, oil, and natural gas—each of which is sourced from various emerging countries. These trends also require large amounts of long-term capital.

While EM corporate bond issuance has a history of more than 30 years, the asset class continuously has matured over time. While many investors may still think of small, unknown regional and niche players when they hear the words “emerging markets,” they are, in fact, home to many strong global enterprises that are viewed as world leaders in their respective industries. The days of EM corporate bonds being excluded entirely from portfolios or investors viewing EM debt as a fringe asset class, acting solely to complement more mainstream assets, are, in our view, behind us. The increases in EM growth rates mentioned above, and the dampening of the volatility of those growth rates has boosted business confidence, and, ultimately, led to an increase in corporate bond issuance. According to J.P. Morgan, as Chart 1 illustrates, dollar-denominated EM corporate bonds have become an asset class difficult to ignore, growing to $1.813 trillion, from just $267 billion in 2004—a 580% increase. Since the credit crisis, the market has expanded by 200%, making it one of the fastest growing fixed-income asset classes. As it stands today, this market is now larger than the U.S. high-yield market ($1.6 trillion) and the U.S. leveraged-loan market ($1.0 trillion), as of February 28, 2017. Not only has the size of the market changed but so has it’s composition. There has been a large shift in risk perception, as emerging fixed-income markets have matured, with roughly 61% of the market now rated investment grade, at ‘BBB’ or higher, versus just 39% at the end of 2000.

 

Chart 1.  The Size and Composition of the EM Corporate Bond Asset Class Has Changed Dramatically.
Total EM corporate external bond stock
US$ in billions; data as of December 31, 2016

Source: J.P. Morgan. Data are the most recent available. Compound annual growth rate (CAGR).
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

According to J.P. Morgan, as Chart 2 indicates, opportunities in this now sizeable market are spread out across 1,192 issues, 552 issuers, and 51 countries encompassing a diversified set of regions and sectors. 

 

Chart 2. EM Corporates Are Diversified Across Regions and Sectors
(As of 12/31/2016)

Source: J.P. Morgan. Based on the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (CEMBI BD). For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Chart 3 illustrates that, on average, EM corporate debt is characterized by wider spreads relative to comparably rated U.S. corporate bonds. This additional compensation exists despite corporate issuers in developing markets employing lower leverage and experiencing lower default rates relative to their U.S. counterparts. What is more, under the methodology of credit ratings agencies, companies generally cannot be rated above their sovereign debt of their country of domicile, meaning that their current corporate ratings may not be an accurate reflection of underlying business fundamentals. Therefore, this incremental yield might be attributable to compensation for sovereign risk, not company-specific risk. 

 

Chart 3. Emerging Market Corporate Debt Historically Has Offered Wider Spreads Than Comparably Rated U.S. Corporate Bonds
Average spread by credit rating, as of February 28, 2017

Source: BofA Merrill Lynch.  U.S. corporate spread by credit quality as represented by the BofA Merrill Lynch U.S. Corporate Master Index.  EM corporate spread by credit quality as represented by the BofA Merrill Lynch High Grade Emerging Markets Corporate Plus Index. The chart is based on the option-adjusted spread for emerging market corporate bonds and U.S. corporate bonds as February 28, 2017. 
Past performance is no guarantee of future results.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.  Credit ratings are derived from a nationally recognized statistical rating organization such as Standard & Poor’s, Moody’s, and Fitch, as an indication of an issuer’s creditworthiness. 

 

The strong positive inflow for this asset class is another element of maturation worth noting. Historically, demand for EM corporates was derived from hedge funds and proprietary institutional trading desks. The asset class later attracted the attention of mutual fund portfolio managers, who invested in EM debt via multi-sector bond funds, and, ultimately, dedicated EM bond funds, expanding the presence of the asset class within the retail marketplace. After the financial crisis of 2008–09, institutional investors, such as sovereign wealth funds, insurance companies, and pension funds, began increasing exposure. More recently, as the global growth and commodities outlook has improved, so has the investor appetite for bonds issued from companies in the emerging markets. Year to date, investors have committed more than $3 billion to EM corporate bond funds, according to HSBC.

For the last three-year period ended February 28, 2017, EM corporate bonds not only provided attractive returns relative to other major asset classes but they also have, in most cases, done so with less risk. Considering that corporate bonds of emerging market issuers are primarily U.S. dollar denominated, it is no surprise they come with less volatility than EM sovereign bonds denominated in local currencies (as represented by the JPM EMBI Global Index) or the local currencies themselves (as represented by the JPM ELMI+ Index). Ultimately, this has led to compelling risk-adjusted excess returns (as measured by the Sharpe ratio). What is more, developing market corporates offer diversification benefits, demonstrating just a 0.25 correlation with U.S. government bonds (as represented by the Bloomberg Barclays U.S. Government Bond Index) over the last three years and a 0.45 correlation with the Bloomberg Barclays Aggregate. Over the last 12 months (ended March 23, 2017), the EM corporate bond market (as measured by the JPM CEMBI Broad Diversified Index) returned 9%. 

 

Chart 4: Historically, EM Corporate Bonds Have Offered Attractive Risk-Adjusted Returns
Trailing three years (as of 02/28/2017)

Source: Morningstar.
Past performance is no guarantee of future results.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

What about the Impact of Rate Hikes?
While consensus typically has been that a tightening monetary policy in the United States is a headwind to emerging market bonds, the tone of the U.S. Federal Reserve’s (Fed) recent rate hike announcement on March 15 has actually eased concerns regarding the potential for hawkish policy in 2017. Indeed, on March 15, the date of the most recent increase in the fed funds target rate, the JPM CEMBI Index rose, and was up 56 basis points for the week ended March 22.

Some may argue that investors are looking past historical trends and are putting a greater emphasis on company fundamentals, allowing EM corporate performance to detach from its typical expected reaction to U.S. policy changes, at least modest ones. A rise in commodity prices stemming from signs of a global economic recovery with the potential for greater infrastructure spending in the United States may have pulled developing market performance off its normal course during this gradual Fed tightening cycle.

Conclusion
U.S. dollar-denominated emerging market corporate bonds recently offered attractive relative yields, portfolio-diversification benefits, and compelling risk-adjusted excess returns. Although spreads have narrowed in recent months, in our opinion, there is reason to be optimistic about the asset class, particularly as the outlook for overall global growth, emerging market growth rates, and commodity prices has improved. 

 

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The Lord Abbett Emerging Markets Corporate Debt mutual fund seeks to deliver current income and long-term growth of capital. View portfolio and more.
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