Is it time to ditch emerging market debt and focus on stocks?

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The restructuring of corporate balance sheets, stabilising commodity and currency markets and receding concerns over the health of China have all helped emerging markets to recover from last year’s sell off.

Both fixed income securities and equities within emerging markets have made progress year-to-date in terms of prices, moving off the lows seen at the start of the year.

But when it comes to getting an income from the region, bonds have been the favoured route for investors, with the desperate hunt for yield across fixed income markets driving up valuations (and forcing down coupon rates).

As a result, the Bloomberg EM USD Investment Grade Bond index is up 9 per cent since 2015, with EM high grade corporate bonds having come through the commodities downturn and the sell off for EM currencies in far better shape than equities. In contrast equities, which fell 34 per cent from peak to trough during 2015’s sell off, are still down 2.5 per cent since the start of last year.

Yield disparity

What this divergence in performance means is that, having previously offered a steeper yield relative to equities, high grade emerging market fixed income is now, on average, paying 2 per cent less than emerging market equities.

As the chart shows, high grade emerging market corporate bonds yield around 3 per cent on average now, well below the average of 5 per cent for many of the highest yielding equities in emerging markets.

As well as lower yields making the sector more vulnerable to shocks, emerging market debt also faces a number of other risks now.

For one, high indebtedness triggered a surge in the number of downgrades to company credit ratings in Q2 this year by the likes of Standard & Poor’s, Moody’s and Fitch which, both in absolute terms as well as relative to the number of upgrades, have reached 2008-2009 financial crisis levels.

Wisdomchart

While the trend has reversed marginally in Q3, credit investors must now be wary of the restructuring of companies’ debt piles, with these moves already on the horizon.

Of course, EM equities have also been impacted by this trend, with some high-profile companies effectively calling on shareholders to bail out bondholders via rights issues or other measures that impacted equity valuations.

However, given the moves we have seen so far for both bonds and equities, the simple fact is equities now look far more attractive from both a yield perspective and in terms of their leverage positions.

More yield for less leverage

The opportunities to invest in equities – which offer both higher yields than bonds and lower leverage – are spread across the emerging markets space.

Investors also need to consider that within bond indices in emerging markets, the strong presence of quasi-government companies distort the picture further. These government-controlled companies are typically focused on achieving the aims of governments, rather than returning value to shareholders, and so their debt issuances can skew indices away from attractive companies in the fixed income space.

Conversely, such companies’ presence in equity markets is far lower, as many do not issue stock or pay dividends, and they are therefore screened out of indices such as the WisdomTree Emerging Markets Equity Income index. Indeed, we estimate that the universe of high grade corporate bonds represent less than one third of the holdings in the WisdomTree Emerging Markets Equity Income UCITS ETF, which tracks the above index.

There is no denying emerging market bonds have enjoyed strong flows from fixed income investors trying to find yield at all costs, but the situation cannot continue indefinitely and investors need to be ready for the moment when the yield of EM fixed income insufficiently compensates investors for risk. That is why emerging market equities, which remain well below previous peaks, offer a better route forward for income hunters now.

Viktor Nossek is director of research at WisdomTree in Europe