CONTRIBUTORS
Mark Hughes, CFA
While emerging market (EM) bonds have exhibited elevated volatility in recent years due to the after-effects of COVID-19 and global central bank tightening, EM corporate bonds have been a bright spot in the fixed-income asset class. Risk-adjusted returns for EM corporates compare favorably to other fixed-income investments (Exhibit 1). There are fundamental reasons for EM corporates’ recent performance, as well as some structural challenges to consider when lending to companies in developing markets.
Exhibit 1: EM Corporates Resilient in the Face of Headwinds—5-Year Risk/Reward Comparison
Source: Bloomberg, JPMorgan. As of September 29, 2023. US High Yield is represented by the Bloomberg US Corporate High-Yield Index; EM Frontier is represented by the J.P. Morgan Next Generation Markets (NEXGEM) Index; EM Corporate is represented by the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI); EM Local is represented by the J.P. Morgan GBI-EM Global Diversified Index; US Credit is represented by the Bloomberg US Credit Index; US Aggregate is represented by the Bloomberg US Aggregate Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Sources of resilience
Why have EM corporates been able to outperform among increased funding costs and messy global growth? Rather than being a levered version of their respective sovereigns, corporate debt issuers in EM countries have adapted over time to be able to weather political and economic stress. Given that their macroeconomic backdrops can be more uncertain than in the US, EM companies often run their balance sheets with less debt than their developed market (DM) peers (Exhibit 2). Also, EM indices contain significant exposure to companies with access to hard currency revenues. For reasons like these, even corporates in countries with challenged sovereign fundamentals such as Argentina and Turkey have generated resilient returns in recent years.
Exhibit 2: EM Credit Leverage Stands Out Among the Rest
Source: JPMorgan. As of June 30, 2023. EM: Emerging Markets; DM: Developed Markets; IG: Investment-Grade; HY: High-Yield.
Structural deficiencies
For EM bond investors, the defensive characteristics of corporate bonds can be very attractive; however, one large difference exists between DM and EM credit: the ability for bondholders to use structure to protect downside credit risk. For both DM and EM investment-grade debt, structure does not often come into play given the typical use of unsecured debt with limited covenants. But when delving into the below-investment-grade space, tools typically used by DM creditors to limit downside (e.g., security, structural seniority and covenants) are more difficult to harness in EM given less developed legal and regulatory environments. And using domestic bankruptcy systems to improve recoveries can be much more challenging for EM, as some investors in insolvent companies in bellwether EM countries such as Brazil and Mexico have, to their dismay, discovered.
Working around structure limits
Despite the aforementioned constraints, EM countries are able to offer a robust high-yield investment universe consisting of newly issued below-investment-grade-rated credits as well as fallen angels. The market over time has adjusted to concerns about credit downside by being more conservative with underwriting across countries, sectors and leverage levels, as well as by de-emphasizing market participants (e.g., private equity) who would typically use structure-aided financial engineering to boost returns. The result across the EM high-yield corporate market is that recoveries in the event of bond defaults are remarkably similar to US high-yield recoveries despite the potential difficulty in EM countries of legally collecting on defaulted debts (Exhibit 3). At Western Asset, we use our deep sovereign research capabilities to understand country-level economic trends and political developments in seeking to limit exposure to credits with the potential for low recoveries. We also emphasize credit characteristics unique to EM corporates that can influence default risk such as uncertain regulatory frameworks and mismatches between hard currency debt and domestic revenues.
Exhibit 3: EM Recovery Rates Compare Favorably to US High-Yield
Source: JPMorgan, Moody’s. *Global EM ex-Russia. Data refers to universes of bonds, not indexes. “Recovery rate” is a term used in credit to describe the bond price of an issuer post-default and is measured in “cents on the dollar” or percentage of par. It describes the severity of the default and the loss relative to par. As of December 31, 2022. Past performance is not an indicator or a guarantee of future results.
Implications for EM private credit
Private credit has been a popular allocation for institutional investors in recent years given high floating-rate yields and optically stable returns. While extending private credit into EM could be an appealing target for investors, we would note that the structural advantages of private credit (e.g., liens, covenants, ability to foreclose) do not necessarily apply to EM investments, for the reasons cited earlier. As a result, we do not expect a similar shift in EM economies from public markets to private markets like what is currently being observed in the US below-investment-grade market. We do expect to see some private transactions marketed for higher-quality EM issuers and/or credits with unique characteristics such as offshore export revenues that could lend themselves to structuring. However, in general, Western Asset continues to believe in the benefits of public market EM corporate exposure, such as disclosure, price discovery and liquidity.
Definitions:
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below.
The J.P. Morgan Next Generation Markets index (NEXGEM) measures the US dollar-denominated external sovereigns debt from frontier markets.
The J.P. Morgan Corporate Emerging Markets Bond (CEMBI) Broad Diversified Index, which is a modified market capitalization-weighted index designed to measure the performance of the US dollar-denominated emerging market corporate bond market.
The J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Broad Diversified Index (US$ Unhedged) tracks local currency bonds issued by emerging markets. Weightings among countries are more evenly distributed within the index than in the global diversified index.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes non-US agencies, sovereigns, supranationals and local authorities.
The Bloomberg US Aggregate Bond Index measures the performance of the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and nonagency).
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.