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Fixed-Income Insights

Global economic and monetary policy conditions could result in a wide variance of returns for emerging-market corporate debt issuers in 2015—potentially creating compelling opportunities for active managers.

 

In Brief

  • The divergent performance among emerging-market (EM) economies that began in 2013 is poised to continue, if not accelerate, throughout 2015.
  • Meanwhile, returns within segments of the EM corporate debt market may vary as well, driven by differences in dependence on oil and other commodities, the strength of export markets, and differences in currency valuation, inflation, and other trade factors.
  • The key takeaway— The performance of investments within the EM corporate debt sector for 2015 likely will depend on effective management of portfolio securities, driven by disciplined, research-based analysis of individual issuers.

 

“Divergence” appears to be the watchword for financial markets in 2015. We’ve already examined the concept on a macro level, namely, as it relates to how economic and monetary policy prospects for the United States differ from the rest of the developed world. At the asset-class level, we’ve discussed how various factors could result in differing returns across sectors of the U.S. high-yield bond market. Now it’s emerging markets’ turn.

The divergent performance among emerging market (EM) economies that began in 2013 should continue, if not accelerate, throughout 2015. Economic growth among EM economies was more or less unified for several years by the collective fiscal and monetary policy responses by developed countries to the 2008 global slowdown. But, in 2013, the performance of EM economies began to vary significantly when anxieties about the consequences of reduced stimulus by the U.S. Federal Reserve—and the associated reduction in global liquidity—raised concerns that some emerging-market economies might find it difficult to attract capital because of significant external debt, inflation problems, or weaker growth. Performance among debt issuers within emerging markets began to vary according to economic differences.

In 2015, the divergent performance of bonds from EM issuers seems likely to become exacerbated by recent drops in the price of oil and other commodities, the difficulty in enacting needed structural reforms in EM economies, and dependence on weak or slowing export markets (e.g., Japan, eurozone, China) versus those with stronger or more persistent growth (e.g., United States, United Kingdom).  Price declines appear to have created attractive valuations in the EM debt sector at the start of the year, but for investors, achieving optimal returns in 2015 likely will depend on the selection of securities from issuers whose fortunes benefit from the macroeconomic factors affecting the market.

Growth, Fed Fears
The dramatic decline in the price of oil and other commodities, combined with weak markets for EM exports, have raised concerns about the profitability of EM companies. Additional fears of slower EM growth and concerns of reduced global liquidity if the Fed raises interest rates in 2015 contributed to a “risk-off” mentality among investors during 2014 and into early 2015. The resulting exit from EM corporate debt pushed down prices, and yield spreads widened, creating historically attractive valuations among U.S. dollar-denominated EM corporate-debt issues. As measured by the JP Morgan CEMBI Diversified Broad Composite Blended Spread Index, spreads on emerging-market corporate debt, relative to underlying government bonds, widened in January 2015, to levels beyond those seen during the  “taper tantrum” in 2013, when the prospect of reduced bond purchases by the Fed spooked fixed-income markets worldwide.

Indeed, it was in 2013 that investors began to fear that rising U.S. rates would compromise the ability of emerging market companies to attract and retain capital. This same fear has been renewed with the Fed’s discussion of raising rates in 2015, combined this time with the economic fragility in the eurozone, Japan, China, and Russia. Such fears have led investors to reduce exposure to the EM corporate debt sector, sometimes, it seems, without regard to the creditworthiness of individual companies.

This “risk-off” behavior is verified by proportionately wider spreads and increasing value among issues with lower credit ratings. For instance, ‘BBB’-rated EM corporate debt traded at a yield 159 basis points (bps) higher than comparable developed-market (DM) debt, as of January 2, 2015, compared with a spread of 114 bps a month earlier and an average of 87 bps since the beginning of 2011, according to data from BofA Merrill Lynch. EM debt rated ‘B’ traded at a spread of 1,028 bps, as of January 2, 2015, compared with 761 bps a month earlier and an average of 445 bps over the last four years.

Different Paths
This is not to suggest that wide spreads among lower-quality securities offer inherent value or that, on balance, spreads are likely to revert to their mean, providing returns proportionate with credit-rating risk. In fact, a reversal of “risk-off” behavior seems unlikely, since the macroeconomic factors of commodity price declines, growth differences among developed markets for EM corporate exports, changes in currency valuation, and the Fed’s likely march toward interest-rate normalization are unlikely to reverse. Investors may eventually acclimate themselves to these risk factors, but returns among EM corporate debt issuers seem likely to be driven by how individual companies are affected by this changed environment.

Returns will in some ways resemble the divergent performance that we expect in the U.S. high-yield market. Companies that are dependent on exports of oil or other commodities facing price declines will fare far differently than those that benefit from lower fuel prices or imports of lower-priced goods. Accordingly, oil-exporting countries, such as Russia, Colombia, and Venezuela, present more difficult economic environments than oil importers, such as Turkey, and other nations, such as India and Indonesia, with better trade conditions. Copper exporters in Peru and Chile, for example, face a more difficult time than beef and non-commodity exporters in a variety of other countries.

Those EM companies whose primary export market is a relatively strong economy such as the United States seem to have better earnings prospects than those that are dependent on the purchasing power within Russia, Japan, and the eurozone. Companies in U.S.-centric Mexico, therefore, offer some potential earnings advantage over Europe-focused firms in Poland, Hungary, or Czechoslovakia. In addition, EM corporate profitability likely will be amplified by currency effects. The strengthening of the U.S. dollar gives EM companies a price advantage when exporting to the United States, and when competing in other markets with U.S. companies. Greater economic hurdles exist for those EM companies exporting to countries with weakening currencies.

Investment Implications
There are few generalizations that can be made about emerging-market corporate debt, aside from the relatively attractive level of valuation, as measured by spreads relative to comparable DM corporate debt. Fed activity may have some broad impact on the performance of this asset class; a slower pace of U.S. interest-rate increases may reduce the flight of capital from emerging-market debt that might be exacerbated if the Fed were to raise rates quickly. But aside from that one broad influence, the returns within emerging-market corporate debt seem poised to be driven by differences according to a dependence on oil and other commodities, the strength of export markets, and differences in currency valuation, inflation, and other terms of trade.

The performance of investments within the emerging-market corporate debt sector for 2015 likely will be less influenced by an investor’s exposure to the overall sector, or even to specific regional areas. Instead, returns may be more a function of effective management of portfolio securities, driven by disciplined, research-based analysis of individual issuers.

 

ABOUT THE AUTHOR

THE EMERGENCE OF DIVERGENCE

What’s the watchword for fixed-income investors in 2015? Divergence. In this series, Zane Brown looks at the prospects for widely varying performance—and investment opportunities—within:

Global Economy & Policy 
High-Yield 
Emerging Markets
• Municipal Bonds

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