Many institutional investors are already invested in hard currency emerging market bonds – often with a focus on government bonds. Emerging market corporate bonds have emerged as an asset class in their own right in recent years, opening up potentially lucrative access to emerging markets.
Emerging market countries have implemented fundamental economic and structural reforms over the past 20 years. Their share of global gross domestic product (GDP) already exceeds 50% and will continue to rise in the coming years, according to the International Monetary Fund (IMF). Since industrialized countries have comparatively high debt relative to GDP and lower growth rates, we believe investments in emerging markets are therefore becoming increasingly important.
In parallel with economic development, we note that the financial markets of the emerging countries have also developed further – especially with regard to corporate bonds. Thanks to its growth and increasing acceptance among investors, this segment is now regarded as an independent and diversified asset class with potential. Compared with government bonds, corporate bonds may offer a broader investment universe due to their diversification across sectors, issuers, and countries. In addition, they also have a lower duration.
Growth and solid returns
Asset class maturity and improved diversification may have contributed to risk mitigation. Emerging market corporate bonds have delivered an annualized return of +5.8% since 2010. This is also true for investment-grade securities, which have posted an annualized return of +5.4% (in USD, JP Morgan CEMBI Broad Diversified (31.12.2021)). The emerging market corporate bond market has grown by 11% annually over the past ten years (Bank of America Securities (31.12.2021)).
By comparison, it is now about one-third larger by volume than the high-yield bond market in the US. The total value of emerging market corporate and government bonds outstanding even exceeds the euro-denominated investment-grade bond universe. Overall, the market volume for investment-grade emerging market corporate bonds is almost as large as the entire emerging market sovereign bond market in hard currency. Further, the high-yield segment of emerging market corporate bonds is now larger than its peer group from Europe. The following chart shows the growth of USD-dominated emerging market bonds.
The risk premium factor As investments in emerging markets are associated with higher risks than investments in developed markets, especially in terms of corporate governance and institutional frameworks, we believe emerging market corporate bonds may offer a higher risk premium to reflect this fact as investors are compensated for the risk taken. In addition, emerging market corporate bonds have a lower duration than their US counterparts and are therefore generally less sensitive to changes in risk-free US Treasuries. We think this is likely to be of particular interest in view of the current discussion on inflation and interest rate hikes by the US Federal Reserve.
The market for emerging market corporate bonds in hard currencies is dominated by investments in USD, and a comparison with the US peer group is therefore representative. If we take fundamental data, such as the net leverage of emerging market corporate bonds, it is clear in the case of the high-yield segment in particular that this is often lower compared with US corporate bonds in the same rating category.
In a relative valuation comparison, high yield corporate bonds from emerging markets currently offer a risk premium of 495 basis points (bps). This represents a current increase of 86 bps relative to the US peer group, with the ten-year average at 30 bps. While the average duration for high yield corporate bonds is 3.9 years, it is 4.1 years for the US peer group (JP Morgan CEMBI Broad Diversified (31.12.2021)).
By contrast, investment-grade corporate bonds from emerging markets currently have a risk premium of 174 bps, which is 49 bps above that of the US peer group (JP Morgan CEMBI Broad Diversified (31.12.2021)). The long-term average here is 72 bps. Another plus point is duration, which at 8.4 years is much higher for the investment-grade US peer group than it is for the investment-grade emerging market corporate bonds at 5.5 years. Credit Suisse believes that this is another reason why hard-currency emerging market corporate bonds could be a potentially interesting investment opportunity.