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Underrated corporate bonds stepping out of the shadows

05.08.2018

Bond investments in Emerging Markets once entailed buying a big stack of government bonds with a sprinkling of corporate bonds. That’s no longer the case. Today, the total market value of EM corporate bonds issued in US dollars has long since overtaken the corresponding market for government bonds. This commentary lays out the opportunities and threats that exist in a market that has stepped out of its own shadow.

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By Søren Bertelsen, Chief Portfolio Manager

The disappointing level of interest rates on European and US government bonds has made bond investors look to securities with higher potential returns, which naturally also come with a higher risk.

Many of them have invested in European and US corporate bonds with low credit ratings or government bonds issued by developing economies in Africa, Latin America, the Middle East and Asia; the so-called Emerging Markets (EM). But a new investment opportunity has appeared in recent years which many of the big professional investors have embraced: bonds issued by companies based in these emerging market countries.

A massive and growing market
It may sound like a niche market but, as the prospects of many EM countries have brightened and the pace of their economic growth has increased, more companies in these countries have started to look for long-term foreign financing of their investments. The local banks and capital providers are not always able to provide such financing, which is why the companies have turned to the international capital markets to acquire the funds they need, primarily in US dollars.

At present, there are bonds worth a total of 1,500 billion US dollars issued by over 1,000 companies in more than 50 countries, meaning this market is in fact even bigger than the far better-known market for EM government bonds issued in dollars.



There are many institutional investors that see this market as an alternative to US and European high-yield securities. Particularly among those who anticipate a higher risk of interest rate hikes in Europe than in the US, EM corporate bonds could be a good alternative. EM corporate bonds are also a good investment when coupled with EM government bonds, as the overall portfolio becomes less vulnerable to interest rate adjustments and leaves you with a higher credit rating than if you were to solely invest in EM government bonds.

Safer than government bonds
But aren't corporate bonds just bonds that carry twice the risk and where you could end up losing money if either the company or the country in which it is based declares bankruptcy?

Not in the emerging markets if you ask the credit rating agencies. They generally rate EM corporate bonds as safer investments than EM government bonds. This is because the issuing companies are generally based in the most stable countries that fall under the leading global index for EM bonds.

For instance, Africa accounts for 12 percent of government bonds issued in the emerging markets, but only 6 percent of corporate bonds, and the majority of these are issued by companies based in South Africa, which is a well-developed economy compared to other countries on the continent.

In Asia, it is stable countries such as Hong Kong, Singapore and Thailand that account for a larger portion of the EM corporate bonds market, and collectively, over half of the bonds in the leading indexes for EM corporate bonds have the highest possible credit rating (investment grade).

Low debt ratio
If you compare the companies behind these EM corporate bonds to their American and European counterparts, one thing that immediately sticks out is their lower debt ratio. American and European companies have taken advantage of the low interest rates in recent years to borrow large sums of money to acquire companies and repurchase shares, which hasn’t always been a cause for celebration among bondholders.



However, companies based in the less stable EM countries have not had the same luxury. They have instead become used to pursuing a more cautious financial strategy, resulting in generally lower debts and a stronger cash position than their counterparts in Europe and the US. All other things being equal, this puts them in a better position to navigate through periods of (geo)political and economic uncertainty.

Crisis after crisis
That said, all other things are most certainly not equal when you compare Europe and the US to the emerging markets. In EM countries, uncertainty is the order of the day. Just look back at the crises in Mexico (1994), Asia (1997), Russia (1998) and Argentina (2001), as well as several crises in Brazil and, most recently, Venezuela (2017). Such a track record would indicate that far more companies in EM countries default on their debts than in Europe and the US.

However, that’s actually not the case, as illustrated by the graph below. This is because international investors are fundamentally more sceptical of EM companies and thus require higher standards for an EM corporate bond investment before they bite. The lower debt ratio provides the companies a buffer, as does the recent years’ generally increasing growth and attractive commodity prices.



Risk of flooding the market

The high growth in the market for EM corporate bonds means that there’s a risk of saturation. That said, the growing interest among international investors, coupled with local investors’ investments in their national flagship companies (and a more stable currency than their own) has been able to absorb the supply thus far.

That's not the whole explanation, however. A growing proportion of the newly issued bonds are for the purpose of refinancing existing bonds, and the total sum of payments from companies to investors (coupons, expiries and buybacks) is now on the same level as the bonds being issued.

The prospects for the EM corporate bonds are closely related to the growth prospects of the global economy as well as the development in commodity prices. Stable or rising growth is essentially good for the emerging markets, while the prospects of a new global trade war is bad news for all types of securities, be it stocks, government bonds or corporate bonds.

Over the course of 2017, we have reefed our sails in relation to our EM bond portfolios, as we see a risk of increased turmoil in the markets. Seen in isolation, global credit markets are not cheap, but they still offer a higher interest rate than European and American government bonds. We expect that good investment opportunities will present themselves over the course of 2018 if the markets take a temporary dive, for instance as a consequence of further friction in the global free market.

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BankInvest manages EM corporate bonds worth a total of 9.3 billion Danish kroner, of which roughly two-thirds are on behalf of pension funds and other institutional investors in Denmark and other countries.

 

Last updated: 05.14.2018