An Asset Class Hard to Ignore

EM corporates surpassing US high-yield market capitalisation

Originally published in the issue

The emerging markets corporate debt asset class has been one of the fastest growing asset classes in the past years – with a growth of nearly 140% in the past three years versus 52% for sovereign emerging markets (EM) debt and 42% for US high-yield – at a time when a good part of the more mature and traditional fixed income or credit markets have been stagnant or shrinking in size. The sub-prime crisis in the US, high leverage in developed countries, new regulations for banks and intermediaries, and low growth have resulted in the reduction or have sharply slowed the growth of agencies, munis, and asset-backed securities.

In the meantime, an affordable fiscal situation in emerging countries and a piling up of forex reserves have resulted in reduced sovereign bond issues, while resilient growth at the EM consumer level, the institutionalization of local emerging investors, and the hunt for yields from global investors have made the place for many new issuers in a very broad range of sectors. The pace of issue of corporates is now twice that of sovereigns and, for the firsttime ever, the market capitalization of the EM corporate debt index (as measured by the J.P. Morgan CEMBI Broad index) has, at $466 billion, surpassed that of the EM sovereign debt index, at $457 billion (EMBI Global).

EM total outstanding euro-bond corporate debt is now also crossing the $1 trillion mark, surpassing US high-yield, and standing at four times the size of European high-yield. Taking into account the local currency corporate debt market, the total outstanding EM corporate debt is close to $2.9 trillion, having doubled in size since 2008, with the local currency segment accounting for 66%. However, the hard currency euro-bond segment remains by far the main investible vehicle for global investors, and is poised to gradually take over the EMBI index as a reference vehicle for hard currency debt investing in emerging markets, all the more since the quality of investments has been improving all along: two-thirds of the debt stock is indeed in high-grade, versus one-third for high-yield.

Issuance remains very impressive, expected to be around $270 billion this year, or running at about the same level as US high-yield.

The corporate debt market was initially more a Latin America phenomenon but is now well diversified geographically speaking. About $330 billion of the debt stock is in Latin America. And for this region, the proportion of high-yield to investment-grade is about the same as for the entire index, i.e., 30% versus 70%.

With low rates being the norm and inflows keeping up pace in the asset class, there have been new issuers almost every week since the beginning of the year. The bulk of the debt stock is now in Brazil which accounts for 42%, followed by Mexico with 26%. Andean issuers have seen a substantial growth too, representing now close to 15%, while one country, Argentina, has been dormant due to the weak sovereign situation – it used to be 10% of the club but is now 2%, or half the size of Peru.

Corporates exhibit resilience
EM corporates exhibit a very attractive risk/reward profile, have survived several stress tests, and continue to offer value relative to developed markets as well as intrinsic value.

In spite of the high supply growth rate of the past years, EM corporate debt has continued to deliver strong returns. Last year it delivered one of the best returns in credit markets, with a 15.22% gain in the CEMBI Broad index and 22.78% in the high-yield segment. Over the past decade, it has delivered very attractive returns in risk-adjusted terms, while being a good source of diversification for global investors. Since 2003, the CEMBI broad index has delivered an annualized rate of 8.80%, while the high-yield segment has delivered 12% versus 10% for US high-yield.

Over the past five years, EM corporate has also survived significant stress tests, and demonstrated resilience as an asset class in spite of many defaults, credit events and changes in participants and liquidity. During the height of the crisis, the EM default rate jumped to 10.7%, a high level, but one in line with the 10.3% in US high-yield at the time. The asset class suffered losses in the range of 15% to 30% for the broad and high-yield segments respectively in 2008 but recovered very quickly versus other asset classes and the class has delivered strong returns since then.

The asset class is also gradually benefiting from a slow but changing structure of investors, with more dedicated investors. The dedicated EM corporate investor base has indeed almost doubled over the past two years: according to J.P. Morgan, total AUM benchmarked against CEMBI now totals $50 billion. However, this still represents only 7% of the market capitalization of the index whereas benchmarked assets against the EMBI represent 50%.

Today, the CEMBI offers a spread of 300bps and running yield of 4.65%, compared to an all-time low spread of 246bps before the 2008 crisis. Looking at the high-yield segment, it is already below its all-time low of 7.3% in yield terms but this continues to offer value in spread terms, trading 240bps above US high-yield.

In Latin America, corporates currently offer a yield of 4.40% and 7.20% in the investment-grade and high-yield segments respectively. 2012 saw some marginal deterioration in fundamentals due to the globalization of the crisis, lower exports, lower commodity prices and a rise of labour costs. However, fundamentals are still of relatively high quality compared to developed markets and compared to the history of the region.

Leverage: Overall, leverage ratios are currently low in emerging markets versus historical standards and also versus developed markets. They are therefore not a significant spread differentiation factor. The spread per unit of leverage is 131bps versus 70bps in developed markets, and it is 150bps versus 100bps when comparing the high-yield segments. The leverage of Latam corporates currently stands at 1.9x EBITDA, which compares with 2.10x in the US.

Refinancing risk: Cash levels have been reduced but near-term maturities are manageable in emerging markets. High-yield maturities start to pick up in 2014 and are more front-loaded than those of US high-yield, with 28% versus 20% of the stock maturing in the next three years. However, the expected conducive primary market conditions continue to support early refinancing. Of note, among the three big emerging markets blocs, Latin America has the best maturity profile, even better than US high-yield.

Default rate: After peaking in 2010, default rates have plummeted to below 1% in EM high-yield thereafter and rose again to 3.8% last year; it is expected to be close to 3-3.5% this year, or not far from its long-term average and versus about 2% expected for US high-yield. Latam is expected to see higher pressure this year, with potential defaults from Mexican homebuilders and Argentinean utilities.

Recovery rates: Comparing the recovery rates of US high-yield versus EM high-yield is a tricky exercise due to the disparities among EM countries but overall experience has shown that recovery rates are not worse in emerging markets. In Mexico for instance, historical recovery rates have ranged from 30 to 50%, versus 40-50% in the US. In contrast to Asia, Latin America has pursued more restructurings through the courts and the recovery value has proven greater in the latest round of restructurings, with recovery value above 50%. Also of note, many EM issuers have engaged in pre-emptive exchanges in recent years, avoiding messy defaults and maximizing recovery values.

Supply: In spite of the very large supply, which has generally averaged around 10% of market size over the past decade over each quarter, we do not see it as a meaningful reason behind the larger spread of EM, given that it has been met with sustained inflows in the asset class.

Liquidity risk: Liquidity has been a differentiating factor as the EM corporate debt market is one of those that can become very illiquid in times of stress as dealers do not keep stock any more and are prone to liquidate any EM names first; however, in normal times, liquidity as measured by bid/offer spread is not that different from other credit markets.

Putting all the pieces together, the main reasons for higher risk premia in EM corporates versus US are: i) the overall country risk or the perception of this risk; ii) the barriers to entry – especially such as information on some private corporates, lack of knowledge and test of local judicial systems; and iii) liquidity factors. The emergence of dedicated investors will help mitigate all these three factors going forward, becoming the main motor for a reduction in the risk premia and less volatility in the asset class.

A challenging macro environment
The macro backdrop behind EM corporates and Latin America is challenging but manageable: it is a region stuck between a ‘new normal’ of low growth on the one hand and the still valid EM consumer and infrastructure convergence story on the other hand.

We are already in the fifth year since the subprime crisis unfolded and contrary to the recent credit cycles, markets have since been living in an uncertain mode, with a succession of fall-out, failed recovery, and a new round of stress as the crisis epicentre has been moving and morphing. For the first time in five years though, there are reasons for a prolonged respite as leverage has been falling across the board. Some signs of growth are emerging in certain developed markets and above all, the perception of risk has been transformed with the expectation of unconventional central bank actions if need be.

This has already spurred a substantial fall in risk premia, translating into a good performance in some equity markets and further spread tightening in high-yield. However, further gains now hinge on the growth or lack-of-growth theme, and this cycle is proving to be selective.

There are two key factors to consider for EM corporates’ health and yields going forward: one is the ‘new normal’ era of low growth in developed countries and the second one is the structural change in China’s growth.

On the one hand, the low growth environment in developed countries should continue to support low rates for a longer period. Low rates in turn continue to support the hunt for yields and provide cheap financing and refinancing for corporates. The normalization will come at a point but may still be a few years forward. The US is currently on a solid recovery path but leverage at the government level and the weakness of its trading partners may continue to constrain growth in spite of the domestic energy boom and the now confirmed recovery in housing.

The Chinese factor is more of a question mark as we are entering unknown territories. The US recovery this year is not taking with it emerging markets nor commodities, as China is now playing a far greater role and its economy is bearing the brunt of a much weaker export sector and a loss of competitiveness, with the US and Japan having recovered a lot of currency and productivity competitiveness and other EM countries competing on labour costs. In the meantime, the rest of BRIC are on their own, faced with domestic challenges that make the likelihood of a return to growth rates seen in the past decade as a remote possibility for now.

Perhaps the current weakness in commodities is not just a short-term cyclical effect, but marks the end of the super commodity boom? From an emerging markets standpoint, this seems hard to validate unless one believes that the EM convergence in particular is over. That would also assume that China’s ongoing structural turnaround is bound to fail. It might be too early to say: the giant country has tremendous micro challenges to solve overcapacity issues in non-profitable sectors and avoid a new rise in non-performing loans (NPLs) but it also has tremendous macro assets such as large financial and public reserves to spend to succeed in this turnaround.

However, should China’s landing in a broader low growth environment be more painful than expected? What happens to Latin America and its corporates in the coming years?

In general, lower demand for raw materials from China should unequivocally weaken Latin America, a large provider of commodities and raw materials. The large commodity players, which happen to be prominent high-grade corporate issuers, should see a further deterioration in their balance sheet at a time when infrastructure needs are calling for significant capital spending.

The softening of the commodity boom will make domestic demand a more important pillar of local growth and though the commodity dividends may not filter in as they used to in the local economies, there are still meaningful structural factors, such as the so-called “demographic dividend”, that make the EM consumer a still valid convergence case. Latin America, in particular, is expected to continue to benefit from a unique demographic position in the next two decades, with a favourable population structure characterized by growing working population and decreasing share of dependent population. This is the most favourable phase of the demographic cycle, a situation that characterized the Asian tigers in recent decades. In less than 20 years, Latam’s economically active urban population will grow nearly 30%. This will naturally stir up GDP growth, offering a strong structural support to the following sectors: retail, healthcare, education, homebuilding, transport, infrastructure, and financial services to name a few.

However, the cyclical context poses some new challenges and the different Latin American countries exhibit significant disparities. Those countries that have capitalized on the last Chinese-led boom are obviously in general better off to face the coming changes. A weakening growth trend in China and an improving growth trend in the US should favour Mexico. The country is also about to complete important structural reforms in the telecom and energy sectors that had been in the back seat for years and should boost and attract investment. Brazil should be at a disadvantage due to its large commodities industry but like China it has strong resources to support its structural growth and Brazil’s growth is, more than in any other BRIC, a domestic story. Andean countries should be at risk given their strong ties with Asia but they all have capitalized on the past commodity boom and countries like Peru and Colombia are currently benefiting from a structural investment and a capital expenditures boom encouraged by a great improvement in fundamentals and more stable political background. Venezuela and Argentina are the two weakest links. Both are in a fragile situation that will be further affected by a fall in commodity prices, should it be more severe and durable. For both, the commodities trend is extremely important in the short term, but with asymmetric effects, as a positive turnaround in prices will not translate into a macro turnaround locally as long as there is no change in the current policy mix to first of all restore confidence in the respective local currencies.

Overall, lower commodity price pressures should also help reduce inflationary pressures, an issue that is still very important in the region and has significantly contributed to the loss in currency competitiveness in the past few years. Lower inflation will keep local rates low and keep local financing afloat for corporates. Overall, in this new normal, Latam countries and corporates should be faced with lower earnings growth but also lower required rates of return.

In spite of a stabilizing global market landscape, the top-down picture is more challenging and likely not a repeat of the past decade for emerging markets, requiring careful attention in the coming years.

Active investing is key
2013 started with very good examples of idiosyncratic sector volatility in Latin America: an active credit strategy should be favoured to capture the asset class opportunities and limit the accidents.

EM corporates have outperformed other EM markets year-to-date thanks to continued inflows and good intrinsic value. After the broad recovery last year, performance has been much more selective this year as micro factors are back to the fore. Latin America has underperformed other regions due to weaknesses in two sectors specifically: i) the large oil investment-grade companies such as Petrobras and Pemex have seen their spreads widened in response to higher capital expenditures and deteriorating leverage; and ii) Mexican homebuilders have suffered from a rapid deterioration in their balance sheet due to rising working capital needs and lower than expected revenues, highlighting weaknesses in their business model. With one company on the verge of restructuring, its competitors have sometimes little choice but to follow the same path so as not to lose a competitive advantage of a cleaner balance sheet.

Recent events there have just shed light on how important is the understanding of the willingness to pay and that a good credit analysis is not just one based on ratios but on understanding the business model, the competition landscape, and knowing the decision-makers to assess both the ability and willingness to pay.

In a low-volatility and low-yield environment, these volatility episodes usually offer good sources of returns when businesses are viable and when the roots of the issues are well addressed and do not spill over to the rest of the market. Some Argentine corporates seem poised to be another source of volatility this year, due to the ongoing issues with the sovereign, the restricted access to US dollars and the consequences of high inflation and controlled tariffs in certain sectors.

Enough diversification and a thorough top-down and bottom-up credit analysis are the main pillars for a successful strategy in this asset class. We expect corporate debt to deliver the best returns in emerging markets in the coming years at a time of much reduced value in EM sovereign and more uncertain prospects for local debt markets and local equity markets, due to less shiny prospects for local currencies as the weak US dollar trend is gradually being reversed.

Federico Carballo is a Portfolio Manager and Florence Duculot, CFA, is Head of Business Development at Copernico Capital Partners