Emerging market economies are now the main driver of global growth and the more canny investors are now beginning to notice this once under-owned and overlooked asset class
Corporate debt has traditionally lingered in the shadows of sovereign debt within the emerging market debt universe. However the tables are turning and we expect that corporate debt could move into centre stage and become the dominant emerging market hard currency asset class in terms of investor appetite and portfolio allocations.
The dominance of emerging market corporate debt can be seen both in terms of market capitalisation as well as new issuance. With corporate issuance at record levels, if current growth rates continue as we expect, this market segment could soon exceed the size of the US high yield market.
Emerging market corporate issuance has been the driver of new supply in emerging markets debt, and cumulative issuance since 2008. Corporate debt issuance is likely to represent over 70 per cent of total emerging market external debt issuance this year, with a forecast (by JP Morgan) to reach $255bn in 2012 versus $80bn for emerging market sovereigns. An important milestone was reached in August this year when the size of the emerging market corporate debt index in terms of market capitalisation surpassed that of sovereign debt for the first time ($469bn versus $463bn in terms of debt outstanding), according to JP Morgan.
One of the favourable points about the corporate debt asset class is that the overall quality is higher than many investors are aware of. For example, although traditionally associated with higher risk investments, the emerging market corporate universe is comprised of more than 70 per cent investment grade issues. The index (JPM CEMBI Diversified) for this high quality asset class has a higher average rating than the emerging market sovereign index (JPM EMBIG). The high credit quality will be further reinforced as more than 80 per cent of new issuance has been rated investment grade in 2012 thus far.
High credit quality is supported by the strong balance sheets of these emerging market companies as well as of the countries where they operate. Today, emerging market countries are the main driver of global growth. Emerging market economies will account for more than 70 per cent of the contribution to global growth in 2012 and are growing at a pace four times that of developed market economies.
As a result of the growing economies, as well as populations and disposable incomes, many emerging market corporates also enjoy strong organic growth which further strengthens their balance sheets and keeps average leverage low despite increased issuance. Additionally, emerging market corporates still currently enjoy favourable cost structures compared with developed market corporates and are further sustained by more attractive labour force demographics.
The macroeconomic environments of many emerging market countries have transformed over the past decade and now offer a stable operating base to private companies. With low debt to GDP ratios and high reserves, compared with their developed markets peers, we believe risks of macrocrisis have significantly diminished in many emerging market countries, thereby minimising one of the major causes of default for emerging market corporates in the past decades. In many ways, the comparison of emerging market corporates to their developed market peers mirrors the comparison of emerging market sovereigns to developed market sovereigns; in most cases displaying cases of lower leverage, better liquidity, and a stronger growth outlook.
At the same time, many emerging market corporates currently have more attractive valuations versus their global peers. On average, for similar credit quality, emerging market corporates offer higher yields and wider spread levels over their US peers while having lower leverage and sounder balance sheets. For example, year-to-date in 2012, BBB-rated emerging market corporates have an average spread level of 331 basis points compared with 237 basis points for US BBB-rated corporates, with almost half the average net leverage, 1.06 versus 1.92 respectively.
It is worth noting however that even though trends for emerging market corporates are positive, including potentially strong growth, relatively low leverage and attractive valuations for the quality of credit, some challenges remain. These challenges are driven by market dynamics as well as investor perception. The unfamiliarity of the asset class leads to a perception of higher risk which in turn can cause short term volatility, moving with market risk sentiments. In addition, secondary market liquidity can be a problem, particularly during times of an overall market downturn.
We expect these issues to improve over time as the asset class develops, and we believe the positive benefits of investing in emerging market corporates far outweigh these challenges. In addition, if the current dynamics continue, spread levels of emerging market sovereigns and corporates should converge. Although the challenges mentioned above may create volatility in the short term, we believe that current valuations and future convergence make now an attractive entry point into the asset class for investors with medium and long-term investment horizons.
Despite the growing prominence, and positive outlook, it is fair to say that corporate debt currently still remains an under owned and overlooked asset class within investors’ portfolios. However, given the pace of growth of the EMD corporate universe, its increasing dominance in the emerging market asset class and recent turbulence in a number of developed markets, we believe that we are approaching a turning point.
Many investors are starting to take note of the positive trends in emerging market corporate credit and we believe it is poised to exceed sovereign debt in investors’ emerging market allocations in the next five years. The increased investor interest combined with a growing number of dedicated emerging markets corporate debt investment funds available is a sign of investors increasingly considering emerging market corporate debt on its own merits, as opposed to a marginal allocation within their global EMD or Global Credit portfolios.
Marge Karner is a senior portfolio manager, emerging market debt, at HSBC Global Asset Management