If the end of last year in emerging markets was dominated by volatility, outflows and fears of a new, protectionist landscape in the wake of the US presidential election, then the start of 2017 has seen a marked turnaround in EM investment trends, which, in the first few months of the year have been dominated by renewed inflows and rising performance, as investors look beyond the headlines and towards the long-term opportunities in the emerging world.
From our perspective, one of the segments that shows a great deal of promise is the often-overlooked corporate debt segment.
A story of rising investor confidence
Emerging market debt (EMD) today is an investment universe of more than $3.5trn, and has grown into a major asset class spanning hard and soft currencies, as well as the government and private sectors.
Corporate debt, most of which is dollar-denominated, now accounts for almost a quarter of this universe. EM corporate debt’s rise can be linked to robust investor demand, rapid long-term EM economic growth, and increasing integration into global capital markets. The fact that demand has kept pace with brisk supply is a sign of investor confidence in the quality of EM corporate debt markets.
The yield premium persists
EM corporate debt has offered higher yield over similarly rated developed market (DM) corporates. Higher yields are in part a reflection of the higher risk premium investors typically require when investing in EM.
But investor perception of risk in emerging markets is changing. Corporate governance is improving in private markets and macro policy across the EM universe is becoming more orthodox. Meanwhile, events in Europe and the US have demonstrated that political risk exists in the developed world, too.
At the company level, fundamentals are improving, as reflected by trends of consolidating leverage and conservative capital expenditure, both of which are positive for credit quality. From a technical point of view, we see a supportive supply outlook in 2017, with relatively subdued net issuance for EM corporates, with the likely exception of China, there is a continued build-up in corporate sector leverage.
Emerging markets see growing corporate debt
Use as a diversifier
Credit cycles across emerging markets are at varying stages and offer a wide spectrum of opportunities. By contrast, the US credit cycle is at a later stage. EM corporate debt offers investors the opportunity to lend to companies that may benefit from an expanding middle class, which makes it a useful means of diversifying DM corporate credit allocations. EM corporate debt can also be used as a diversifier due to low historical correlations with traditional fixed income (for instance the Bloomberg Barclays Aggregate Bond index). When compared with EM sovereign debt, the sector typically has a lower duration but higher credit quality, and in our view can serve as an attractive extension to existing EM allocations.
Security selection matters
The EM corporate universe includes over 540 issuers across more than 50 countries. We see opportunities for skilled security selection arising more frequently when compared to developed markets, in part because the EM corporate sector receives less coverage by research analysts. Rigorous fundamental research can help identify idiosyncratic opportunities where return potential adequately compensates for the associated risk, while foregoing areas of undue credit risk. Alongside this exists a need to examine macro and credit conditions in individual EM countries; EM is no monolithic bloc. We think active managers can add alpha by understanding each country’s position in the economic cycle and identifying sovereign tail risks which may impact the corporate sector.
Angus Bell is portfolio manager for global fixed income at Goldman Sachs Asset Management