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There is a widely held belief that emerging market corporate bonds necessarily imply higher risk for investors. Many investors indeed feel more comfortable investing in their country of residence or close to their home country, as Warren Buffett mentioned in an interview in the Financial Times [1].

Developed countries versus emerging markets

Admittedly, the developed bond markets in North America, Western Europe and Japan offer a more stable infrastructure: rule of law and a well-implemented set of regulations including competition law, company insolvency law and financial conduct supervision. It is only natural that investors have doubts on the trustworthiness of corporate issuers operating in the emerging economies (encompassing Latin America, Middle East & Africa, Central & Eastern Europe and Asia excluding Japan).

A less unstable equation than might be expected

The capacity of EM companies to honour their debt often proves to be higher than expected. In the last two years, the corporate default rate in emerging economies has been lower than in the United States: the high-yield issuer default rate was at 1.87% in the US in year-end 2018, whereas it remained at 1.6% in overall emerging countries in the same period [2]. In the Middle East and Africa, the figure even fell below average, at under 0.1%. This trend continued into the first quarter of 2019, with an extremely low default rate of 0.5% for EM speculative grade corporate bond issuers [3]. In contrast, the biggest corporate defaults by volume have happened in the United States.

To mention only a few: Toys ‘R’ Us, iHeartCommunications and Sears Holding have filed for Chapter 11 bankruptcy protection. This phenomenon is due to the fact that 64.6% of all global corporate debt consists of bonds and leveraged loans issued by US companies [4]. In fact, more than 45% of US GDP comprises corporate debt issued by non-financial sector companies [5]. According to a report published by BCA Research [6], the growth rate of corporate debt was highest in the United States in 2018, which could pose serious risks for the economy. The deteriorating indicators of corporate fundamentals and financial risk-taking even point to late-cycle dynamics, failing to engage in long-term capital spending [7].

Emerging market companies’ fundamentals prove their credit quality

Corporate bonds issued by emerging market companies are not intrinsically riskier than those issued by sector peers in the developed part of the world. Nevertheless, the close relationship between sovereign credit rating and the credit rating of a company based in that specific country raises a question: why do the credit ratings of emerging market corporates diverge to a higher extent than their developed-market peers? The explanation is simple. They move in synchronization with the sovereign credit rating of the country of domiciliation.

The sovereign credit rating even determines the scale of ratings upgrades or downgrades. For instance, more than five Turkish corporate issuers saw their ratings downgraded to BB- in the aftermath of the ratings downgrade on the Turkish sovereign. On the other hand, some corporate issuers have received higher ratings than those of their domicile. Such is the case for Emirates Telecommunications Group, rated AA- by S&P [8] (Aa3 by Moody's), above the sovereign rating of the United Arab Emirates.

The positive credit assessment is mostly based on the excellence of its financial metrics, especially the low leverage ratio, the ample interest coverage and significant cash on the balance sheet. The group also offers the competitive advantage of generating cash flow in several countries where it operates outside its home country, such as Morocco, Egypt, Pakistan and the Central Africa region.

This demonstrates that a company operating in emerging markets can post financial health that is as solid as its competitors in developed markets.

Higher spreads – drawback of emerging market bonds

Even so, every rose has its thorn. Investors have to accept higher credit spreads when buying bonds issued by companies whose parent group is located in an emerging market. Credit spreads represent the difference between the yield on a low-risk bond and the yield on a corporate bond. A big difference (or high spread) means a greater credit risk but also a higher return for the bond in question.

According to a report published by the J.P. Morgan credit research department [9], A-rated corporate bonds from EM issuers tend to have spreads 29 to 50 basis points above equivalent bonds issued in the United States, all other things being equal (‘pari passu’). This observation could be due to the fact that financial markets factor in the liquidity issue for emerging markets in their pricing. In addition, the higher the credit rating, the narrower the spreads to sector peers in the same ratings basket. This explains the significant level of spreads on high-yield debt issued by emerging market companies.

The ultimate parent company’s country of domiciliation also plays a role: for instance, Russian corporates with the lowest investment grade, BBB-, display wider spreads ranging from 95 to 106 basis points to the US issuers in the same sector. This takes into account geopolitical risks on top of the counterparty credit risks, such as the impact of US sanctions on the Russian economy. Lastly, in some sectors, such as banking and financial services, EM issuers post higher spreads (over 100 basis points) than their US counterparts with the same credit rating.

In conclusion, it is of little practical value to believe that EM corporate bonds do not comprise a safe asset class. An exhaustive credit assessment of emerging market credit can enhance the degree of diversification in an investment portfolio.

 
[1] The Financial Times, Weekend Long Reads, 25/04/2019
https://www.ft.com

[2] J.P. Morgan Credit Research, EM Corporate Default Monitor, 04/04/2019 https://markets.jpmorgan.com

[3] S&P Capital IQ, S&P Global Ratings, Credit Trends Report, 15/04/2019
https://www.capitaliq.com

[4] J.P. Morgan Credit Research, Default Monitor, 02/01/2019

[5] BCA Research, Special Report on the risk from U.S. Corporate Debt : Theory and Evidence by Ryan Swift, 23/04/2019

[6] idem.

[7] The Financial Times, Corporate America is failing to invest, Gillian Tett, 11/04/2019
https://www.ft.com

[8] S&P credit rating report, Emirates Telecommunications Group Company, 11/06/2018

[9] EM vs. US HG Relative Value Report, 22/04/19, by Eric Beinstein & Yang-Myung Hong https://markets.jpmorgan.com

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