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Market View

Emerging-market (EM) corporate bonds denominated in U.S. dollars got swept up in the broader concerns about an EM debt crisis. We think the time is right to take another look at the asset class.

Two of the biggest concerns emerging market (EM) investors had in 2015 were the decline in global economic growth, especially in China, a major trading partner for developing nations, and the consequent fall in demand for commodities, a key export for many emerging markets. Adding to the complexity of macroeconomic concerns were the reports from international agencies of significantly high levels of EM debt as a percentage of gross domestic product (GDP). Media stoked the fire with reports of an impending EM debt crisis.  

It was almost inevitable, then, given such a gloomy backdrop, that some investors would choose to disinvest from emerging markets, despite the long-term investment opportunity they represent. U.S. mutual fund outflows were significant in all EM asset categories in 2015 and early in 2016. But late in February and so far in March, we are seeing some stabilization in EM fund flows. And while there can be no guarantee that we have hit bottom in this market, valuations, some of them at distressed levels, are deserving of renewed attention on the part of investors, according to Jerry Lanzotti, Lord Abbett Partner and Portfolio Manager. We believe that investors may want to revisit the investment opportunities in the U.S. dollar-denominated corporate bond sector, for the following four reasons: 

Reason 1: A Largely Investment-Grade Asset Class
Emerging-market companies that issue external debt (that is, bonds issued in other than a local currency) tend to be among the best-managed businesses in their markets. Their choice of currency is typically the U.S. dollar. Many of them already have a long experience with bond issuance, some going back 30 years, and a little more than 70% of them were rated investment grade, at ‘BBB’ or higher, as recently as 2014. In 2015, some of these companies, particularly energy and metals and mining companies in Brazil and Russia, slipped into the high-yield category (securities called “fallen angels”), reflecting sovereign downgrades as well as the sharp slowdown in their respective sectors, bringing the number of companies rated investment grade to a bit more than 61% today, according to J.P. Morgan, but still well above the 40% level a decade ago. A number of these so-called fallen angels are quasi-sovereigns, with every expectation of being supported by their respective countries of origin. At current low valuations, we believe they offer investment opportunity.  

Reason 2: High Yields, Despite Investment-Grade Ratings
Despite the market’s largely investment-grade rating, the EM external corporate debt retains a broad reputation as a high-yield debt substitute. So, EM corporate bonds historically have tended to have higher yields than their comparably rated counterparts in developed markets. Moreover, under credit ratings methodology, companies generally cannot be rated above their country’s sovereign debt rating. This is an important fact to consider, because it could mean that a company’s credit rating may not be an accurate reflection of its underlying business fundamentals, thus there may be an opportunity overlooked. For example, in 2015, some Brazilian company names suffered chiefly because the nation’s sovereign debt was downgraded. 

 

Chart 1: Historically, EM Corporates Have Offered More Attractive Yields Than U.S. Corporates
Average yield by credit rating (as of February 29, 2016)

Source: BofA Merrill Lynch and J.P. Morgan. *U.S. corporate yields by credit quality as represented by the BofA/Merrill Lynch U.S. Corporate Master Index. **EM corporate yields by credit quality as represented by the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (CEMBI BD). The historical data shown are for illustrative purposes only and do 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.

 

For a fundamentals-driven, active EM debt manager, these factors provide a long-term opportunity to invest in a higher-yielding name that, on a global comparative basis, may represent a more sound credit. 

For investors, at a time when negative rates are becoming commonplace in some developed-country sovereign bonds, the comparatively higher yields of EM external corporate debt are attractive.

Reason 3: A Large and Growing Asset Class
The EM external corporate debt market is growing at the fastest pace of any fixed-income asset class.  While still a small percentage of the overall credit market, the amount of external EM corporate debt outstanding is seven times larger than it was a decade ago, according to Barclays, with one of every five U.S. dollars of global corporate issuance now coming from an emerging-market company.

The fast pace of growth reflects the markets’ growing acceptance of the asset class as well as an improvement in tradability. This is in part because of the growing issuance size, which has characterized the asset class since 2009. During 2012, for example, the typical benchmark-size issue for EM corporates was $500 million to $1.0 billion, well within the range of developed-country benchmarked-sized issues. Notably in recent years were multibillion dollar deals, largely issues by quasi-sovereigns. 

Moreover, the market is a large one. Bonds outstanding in this category reached $1.7 trillion by the end of 2015, according to J.P. Morgan, double the size of EM external sovereigns at ($736 billion as of December 31, 2015) and approaching the size of the global U.S. dollar-denominated high-yield market ($1.8 trillion). 

EM corporate debt also constitutes an increasingly higher percentage of the overall trading volume for all EM external debt in the secondary market. According to Emerging Market Traders (a trade forum for EM investors and dealers), trading in the asset class set a high-water mark in 2010 on a U.S. dollar basis and generally has continued at a robust pace since then. 

With volume and tradable issuance size up, and a robust secondary market, liquidity across the EM corporate sector has improved dramatically. 

While this is a large and growing asset class, there are only a handful of mutual funds dedicated to this space. Most EM debt funds are primarily invested in sovereign debt, denominated in either local or foreign currency. And as Chart 2 shows, EM corporate bonds historically have outperformed other EM bonds, including both local currency and external currency sovereign bonds, during periods when other EM bonds have faltered.

 

Chart 2: EM Corporates Have Held Up Best When Other EM Bonds Faltered
Growth of $100,000 over the last three years (February 28, 2013–February 29, 2016)

Source: Morningstar. EM bonds as represented by the following indexes in descending order: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified (CEMBI BD), J.P. Morgan Emerging Markets Bond Index Global (EMBI Global), and J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified, respectively. EM Bond Category represents the Morningstar Emerging Market Bond Category. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. The historical data shown are for illustrative purposes only and do 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.

 

Reason 4: Representing a Small Percentage of GDP
External corporate bonds are not the major problem in the debt overhang cited by international reports. This is not, however, to downplay the risks; the rise in EM debt levels in general could present challenges to EM growth, as debt-servicing costs increase. And as a percentage of GDP, EM private sector debt, including corporate and household debt, reached a not-insignificant 104.1% of GDP in 2014, according to J.P. Morgan. But the bulk of the funding consisted of loans by domestic banks to companies most likely unable to access the bond markets (60% of GDP), followed by household credit (29.5%). Corporate external debt accounted for only 3.8% of GDP. The composition alone of private sector debt reduces the likelihood of an EM external debt crisis—a point seldom mentioned in news reports.  

 

Chart 3: EM Corporate Funding Is Healthy; Domestic and Private Loans Are Bulk of Credit
Percentage of GDP (as of December 31, 2015)

Source: J.P. Morgan. Breakdowns may not sum to whole due to sample differences.

 

A Final Word
EM corporate defaults rose a bit in 2015, according to Lanzotti, mostly in the commodity and energy sectors—which is not a very surprising development given the macroeconomic background during the year. And EM company leverage overall has increased to levels more typical of U.S. companies. “But it’s important to note,” Lanzotti said, “that unlike U.S. companies that have been issuing bonds to buy back stock or to fund mergers and acquisitions, EM companies have been funding capital expenditures for future growth or to refinance, as issues matured, the more expensive debt they had been carrying. This is reflective of the more conservative style of management that we have come to expect in established EM companies.”   

Depending on an investor’s tolerance for risk, EM external corporate debt might be a well-considered addition to a diversified portfolio.  

 

MARKET VIEW PDFs


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