Profits and perils: Positioning in emerging market corporate debt

We believe investors looking for compelling investment opportunities should consider an allocation to emerging market (EM) corporate debt. The asset class offers relatively high yields in conjunction with strong credit fundamentals and attractive diversification benefits. Furthermore, we believe a constructive macroeconomic backdrop should support performance going forward.

EM corporate debt: A story of fundamental strength…

While this might surprise those who are less familiar with the asset class, more than two-thirds of the bonds included in the main EM corporate debt index, the ICE BofA EM Corporate Plus (EMCB) Index, have an investment-grade (IG) credit rating. Exhibit 1 shows the index breakdown between rated IG and high yield (HY) securities.

The average bond held in the EMCB Index is rated BBB, as of August 30, 2024, and this quality trend continues to improve, with the ratio of credit rating upgrades to downgrades recently reaching a decade high. EM corporate issuers typically have lower levels of net leverage compared to their US counterparts, while also maintaining solid interest coverage ratios, which supports issuers’ ability to service debt. These strong financial profiles are often due to the conservative approach of management teams, which aligns with the relatively high-quality standards required for issuing debt to international investors.

A constructive macroeconomic backdrop further supports this general picture of fundamental strength. As global inflationary pressures ease, central banks are able to loosen monetary policy in support of economic growth. The US Federal Reserve is embarking on an interest-rate cutting cycle, which should give EM central banks additional room to ease their own monetary conditions. Looking forward, EM economies are expected to continue to outperform their developed market counterparts, with a noteworthy pickup in growth across central and eastern Europe and several Asian countries.

However, following Donald Trump’s presidential election victory and the associated risk of higher tariffs and more widespread sanctions which could weigh on global growth, it is important to note that EM corporates are much less dependent on the United States than they once were. As mentioned above, the asset class has seen continuous fundamental improvements, while a growing middle class and greater regional dependence support its resilience to fluctuations in the global economy. This diversified and improving fundamental profile informs our positive longer-term view of the EM corporate bond asset class despite any potential exogenous shocks that might arise during Trump’s presidency.

…and a supportive technical backdrop

After a couple years of heightened uncertainty—caused by surging inflation and aggressive monetary policy tightening—the backdrop has become more constructive for fixed income investors. This is reflected in the renewed interest in EM debt. EM corporates in particular can offer a host of potential benefits to investors, including attractive yields (as seen in Exhibit 2 below) and considerable diversification.

The yield on EM corporate bonds is compelling, in our view. As of the end of September 2024, the average yield on the EMCB Index remained above 5.50%, which is not only elevated compared with historical levels but also considering alternatives in Europe and the United States.

Not only is demand for EM corporates healthy, but the sector is also large and growing and offers plenty of investment opportunities. The asset class has recorded dynamic growth over the past two decades (as seen below in Exhibit 3) and is now larger, in terms of outstanding debt, than the EM sovereign bond and US HY bond markets.¹ In conjunction with its expansion, the asset class has become increasingly diversified across countries, regions, sectors and market capitalization. In fact, the EMCB benchmark consists of more than 2,000 bonds from approximately 840 issuers across around 300 country sectors (i.e., sectors within countries).

The breadth of this market results in attractive correlations to many other fixed income sectors, —and a compelling Sharpe ratio.²  This, in turn, means that adding EM corporate bonds can have significant diversification benefits for portfolios.

Conclusion

Compelling yields, significant diversification potential, and robust credit quality combine to make EM corporate debt an attractive option for fixed income investors. Over the near to medium term, declining yields, looser monetary policy, a strong growth outlook and increased investment flows should support the asset class. We therefore believe that now is the time to increase portfolio allocations to this multi-faceted sector.