Rising inflation, monetary tightening, and recession, have impacted risk assets during 2022, with investors looking to identify an attractive yield amid concerns around global growth, inflation, and geopolitics.
All asset classes have suffered, but some have suffered more than others. Global equities are down 17.5%* year to date, whilst US investment grade bonds are down 13.8%*. A glance at the performance of the key asset classes shows that ‘hard currency’ emerging market corporate debt has fared better than most. This asset class has traditionally been overlooked by investors, but it has been gradually gaining attention on account of its relative recent performance.
The emerging market debt asset class is worth around USD 26.3 trillion overall and spans numerous mostly developing countries, thousands of issuers, and a wide range of sectors. The asset class has significantly matured over the past two decades and is no longer a play on commodities; it is today a broader, more diversified, and genuinely stronger asset class, but one needs to distinguish two separate categories – sovereign debt and corporate debt.
The emerging market sovereign debt segment – issued by governments – accounts for most of the emerging market debt universe – USD 13.6 trillion, of which USD 12.6 trillion equivalent is denominated in local currency – and as such tends to attract the most attention from market observers. Erratic economic developments, political risks, and foreign exchange volatility – which are more difficult to analyse, quantify and control – have all contributed to the high-risk image of the asset class.
However, ‘hard currency’ emerging market corporate debt, the risk profile of which is mostly driven by the companies’ fundamentals, suffers from its association with the emerging market sovereign debt asset class. As a result, its perceived risks are, in our view, significantly greater than the actual risks associated with the underlying corporates as the latter’s financial and business strength more than offset the local risks.
A quality company with strong and sustainable competitive positions, generating predictable cash flow, is in a solid position to repay the debt, regardless of where it is located. However, a quality company based in a developed market would pay a yield considerably lower than if it were based in an emerging market, because it is perceived as a lower risk. In short, investors in hard currency emerging market corporate debt are paid a premium for investing in companies based on the rating of the country they are based in, even if they are global companies with diversified sources of revenue and solid fundamentals. Hard currency emerging market corporate debt currently provides investors with a yield of 5% and a yield to maturity of 7%. This is a higher yield than in March 2020 when the global pandemic was declared.
The perception of the underlying corporate fundamentals is part of the issue itself. One would expect emerging market companies to compare poorly against their developed market peers, but the reality is quite different. Based on two metrics, which are core to all credit investments – leverage and default rates – emerging market corporate debt compares very favourably. Quality emerging market corporates often boast healthier balance sheets than developed market peers, with net leverage at the lowest levels in a decade.
Alongside the higher yields, the asset class provides diversification benefits – particularly when combined with developed market equities and fixed income – to typical asset allocation. By way of example, emerging markets have a correlation of only 57% to US investment-grade bonds, and just 45% to US equities.
Of course, no asset class is immune from the current challenges facing investors. With global monetary tightening and higher rates, short-term volatility is likely to remain a feature of the market as it shifts its attention between concerns about the persistence of inflation and recession, and the implications for monetary policy. US rate expectations will likely need to be anchored before markets stabilise.
Emerging market corporate credit ratings are very often constrained by sovereign ratings, so we may well see some downward pressure; sovereign balance sheets deteriorated as the public sector bore much of the COVID response, although it was more contained in emerging markets than in developed markets. Furthermore, there is likely to be political uncertainty in several countries given the election calendar, which may increase volatility in asset prices. Meanwhile any escalation in geopolitical risks, most notably between China and Taiwan, and Russia and Ukraine, would weigh on risk sentiment more broadly.
But while there are reasons to be cautious on the macro, as with any market, developing or otherwise, company fundamentals matter. As Charlie Munger, Warren Buffett’s colleague once famously said, “Micro is what we do, macro is what we put up with.” Buffett and Munger do not time markets but base their investment decisions on fundamentals. Likewise, our long-held view is that investment decisions should be formed from the bottom up, and that you should look at what companies are doing, and what opportunities they’re seeing. You should not worry or be swayed by macroeconomic conditions or short-term market concerns.
In the emerging market corporate debt space, selective corporate balance sheets are in very good shape, albeit companies could face some margin pressure near term from higher costs, and given post-pandemic recovery a pick-up in CAPEX, and that could see leverage trend up marginally. But in our experience, quality companies that have strong and sustainable competitive positions, operating in good and growing industries, with predictable cash flows, the financial strength to weather adversity, access to multiple sources of capital, and strong management teams, are in a solid position to repay the debt, regardless of their location.
The asset class (currently down -13%) has weathered similar periods in the past, and investors who have stuck with it have been well rewarded. The emerging market high-yield component of the asset class has generated over 7% annualised returns (in US dollar terms) over the last two decades with very few down years. Therefore, whilst there are macro-economic headwinds in sight, we believe that so long as you invest in quality corporates, an emerging market debt strategy will generate an attractive level of return from an income and total return point of view.