The amount of emerging market (EM) debt and the variety of instruments have evolved significantly, not only over the past decade but also since the global financial crisis. In stark contrast to what has occurred in developed markets (DM), the financial crisis and the uneven recovery we call the New Normal have not derailed the steady improvement in EM sovereign balance sheets and fiscal accounts. As a result, EM debt has become increasingly attractive to global investors.
Against this backdrop, however, EM sovereign governments have started to issue more debt in their own currencies rather than in U.S. dollars. Bonds from EM countries with less debt have traded at “scarcity” premiums, and yields on EM sovereign bonds in general have fallen to record low levels, alongside those of DM investment grade and high yield corporate bonds.
In contrast, emerging market companies have been increasingly issuing debt in hard currencies, funding in the world’s deepest pools of capital at significantly longer tenors and in many cases, lower absolute yields than in their home markets. We believe this growth presents new opportunities for global investors. PIMCO has long found EM corporate bonds attractive relative to DM corporate bonds (see Featured Solution, “You Can No Longer Say Corporates Without EM,” March 2012), and now, we also see value in tactical allocations to EM corporate bonds within EM sovereign portfolios. In our view, EM corporates, especially partly or wholly state-owned “quasi-sovereigns,” can potentially provide two big advantages in today’s low interest rate environment: higher yields and shorter durations.
How big is the EM corporate bond market?
The answer is: big. The stock of EM corporate bonds outstanding has grown to around US$1 trillion, dwarfing that of EM sovereigns at $680 billion. Moreover, in August the market capitalization of J.P. Morgan’s EM corporate debt index, the CEMBI Broad, surpassed that of J.P. Morgan’s EM sovereign debt index, the EMBI Global ($466 billion vs. $457 billion). New issuance by EM sovereigns in September put the market capitalization of the EMBIG back on top ($555 billion vs. $538 billion for the CEMBI Broad), but the trend toward greater issuance by EM corporates relative to EM sovereigns remains intact.
Annual EM corporate issuance has increased dramatically from just over $20 billion in 2002 to about $200 billion on average since 2010. As Figure 1 shows, EM corporate issuance has outstripped EM sovereign issuance every year since 2003, with the corporate-to-sovereign issuance ratio now running at more than 3:1. The EM corporate market is also well-diversified, with about 350 issuers from 38 countries across a dozen sectors, according to J.P. Morgan.
One indicator of the growth in the EM hard currency corporate market is the changing composition of the EMBI Global, or EMBIG. The share of quasi-sovereigns in the EMBIG has grown from 6% in January 2002 to almost 23% as of 14 Sept. 2012.
How can EM corporates add value to EM sovereign portfolios?
PIMCO believes that EM corporates, especially quasi-sovereigns, can add value to EM sovereign portfolios in a variety of ways.
The first is higher yields. EM quasi-sovereigns that are not part of the widely replicated J.P. Morgan emerging market sovereign bond indexes (the “EMBI indexes”) may allow for an attractive yield pickup relative to their sovereigns. For example, in mid-September, bonds issued by the state-owned Brazilian multinational energy company, Petrobras, maturing in 2021 had an option-adjusted credit spread over LIBOR (LOAS) 130 to 140 basis points (bps) higher than a comparable bond issued by Brazil. For investors with deep credit research resources, private sector corporate bonds can provide even greater spreads and yields over their respective sovereigns.
EM corporates can also be used to replace EM sovereign bonds issued by countries that a portfolio manager no longer wants in the portfolio – including sovereign bonds with solid fundamentals but less attractive risk-adjusted yields. This is not uncommon with EM countries that have a weighting of 0.50% or less in the EMBI indexes: Because supply is limited, investors aiming to replicate an index may pay “scarcity” premiums for the bonds, and risk-adjusted yields may become unattractive. Half of the 50 countries in the EMBIG have weightings of 0.45% or less, while almost 80% of the $60.5 billion in year-to-date investor flows into EM debt has been invested in U.S.-dollar-denominated strategies benchmarked to the EMBI indexes. Over the next few years, we expect this trend to continue as smaller countries issue debt for the first time in the international capital markets, drawn to record low U.S. dollar yields and investor appetite for bonds yielding more than U.S. Treasuries. Indeed, Latvia, Azerbaijan, Guatemala and Mongolia have joined the EMBIG this year alone, with Angola, India and Zambia likely to join in the next few months. Even Bolivia issued bonds in October for the first time in decades.
EM corporates as an asset class also have generally lower interest rate duration compared with EM sovereigns. The interest rate duration of the CEMBI Broad was 5.55 years compared with 7.57 years for the EMBIG as of 28 Sept. 2012. With 10-year U.S. Treasury yields near historical lows, EM corporates’ shorter maturities can help reduce interest rate exposure – and the risk of loss if interest rates rise – within an EM sovereign bond portfolio.
Choosing the right corporate in the right country is key
Despite the current opportunities we see in EM corporates, a dollar invested in a portfolio passively managed to the CEMBI Broad has underperformed a dollar invested in a portfolio passively managed to the EMBIG during the past 10 years (Figure 2). In our view, this argues in favor of active management of EM bonds relative to their benchmarks, especially in corporates. But we also believe such an index-level comparison misses important relative value opportunities between corporates and sovereigns at the country level.
In certain EM countries, an investor would have been far better off investing in corporates rather than sovereigns during the New Normal. Figures 3, 4 and 5 compare the returns of a dollar invested in quasi-sovereigns, corporate bonds and sovereign bonds in Russia, Indonesia and Chile since the Lehman bankruptcy in September 2008. In the case of Indonesia, the differences in favor of quasi-sovereigns and private sector corporates are especially striking.
We believe these examples highlight the importance of actively managing EM portfolios that do not passively seek to mimic an index. By taking advantage of opportunities in the corporate bond markets outside of the EM indexes, a portfolio manager can potentially add return above the benchmark to an EM sovereign bond portfolio.
Not all quasi-sovereigns are the same
One of the most important factors in EM corporate bond investing is the distinction between quasi-sovereign corporates and pure private sector corporates. While “quasi-sovereign” implies substantial sovereign ownership or control, in fact, ownership can be as low as 50.01% and as high as 100% of equity capital. PIMCO uses sovereign ownership of greater than 50% as the criterion to classify an EM corporate as a quasi-sovereign.
Sovereign ownership per se doesn’t necessarily guarantee sovereign support. For example, a property developer majority owned by the Emirate of Dubai was forced to restructure $25 billion in debt following a severe downturn in Dubai real estate prices in 2007–2009. Not all Dubai-owned entities defaulted, however; others either had the wherewithal to continue servicing debt or were deemed to be systemically important to the sovereign.
The systemic importance of a company to its sovereign may play a larger role than formal ownership. Some less-than-100%-owned EM companies, such as the leading energy companies of Russia and Brazil, have an outsized footprint in their respective economies, generating a significant amount of a country’s exports, tax receipts, overall GDP and employment. As early as December 2008, in response to the global financial crisis, the Russian Federation published a list of 295 strategically important companies that the government was ready to fund and assist; many of the listed companies were not even partially owned by the Russian sovereign. Even in the dark days of EM debt restructurings in the 1980s, some quasi-sovereigns restructured their debts under agreements guaranteed by their sovereigns – even when the original debt was not guaranteed by the sovereign.
To avoid negative surprises, investors in quasi-sovereigns need to watch closely for any indications of a change in control. As part of a fiscal consolidation, some EM countries have privatized state-owned or -controlled enterprises to generate fiscal revenue. Many, but not all, bond covenants have a “change of control clause” that allows investors to exercise a put at par if the state’s share falls below a certain level (usually below a controlling stake).
Corporate credit risk and lower liquidity remain an issue
The incremental yield EM corporates offer over EM sovereign bonds is of course related to corporate credit risk, which makes thorough credit analysis essential. It also reflects the greater regulatory and bankruptcy-related uncertainty in EM corporates compared with DM corporate and EM sovereign bonds.
One of the reasons EM corporates have underperformed EM sovereigns at the index level is that EM corporates have lacked the dedicated investor base that EM sovereigns enjoy. As a result, liquidity, although improved in recent years, remains lower than for EM sovereigns. And in times of market stress, EM corporates and quasi-sovereigns tend to underperform as crossover investors decrease their exposure to non-benchmark issuers.
As a dedicated investor base in EM corporates continues to grow, we think higher trading volumes and better liquidity will result. Over time, this should lead to lower liquidity premiums relative to EM sovereign bonds, and in our view, this spread compression is a potential source of alpha.
Looking beyond the benchmarks
As the emerging market debt asset class evolves, we believe investors with EM sovereign bond portfolios can benefit from moving beyond their benchmarks to take advantage of tactical opportunities in the corporate sector. In our view, EM corporates, especially quasi-sovereigns, can help improve yields and reduce duration risk in EM sovereign portfolios at a time when U.S. interest rates are close to historical lows. For investors with the appropriate level of credit research resources, adding high quality EM private sector corporates to an EM sovereign portfolio may enhance the portfolio even more due to their higher yields.