A milestone was reached last month in the world of emerging market corporate bonds: Brazilian state-run oil company Petróleo Brasileiro (Petrobras) sold a US$7 billion bond offering, the biggest ever U.S. dollar-denominated bond issue by an emerging market (EM) corporation, reported the Wall Street Journal. That record deal highlights the growing prominence of corporate bonds within the EM asset class and kicks off a potentially important year in their evolution.
Yet, EM corporate bonds (EMCBs) are generally not nearly as well-known as their EM sovereign counterpart, despite a long history of issuance by EM corporations. It may come as a surprise that issuance of U.S. dollar-denominated EMCBs exceeded US$200 billion in 2011 – considerably more than EM sovereign bond issuance – or that many EM corporations have been issuing bonds in the international markets since the early 1990s, according to PIMCO research. Moreover, the size of the tradable market for EMCBs totaled about US$1 trillion in 2010, which was significantly larger than the US$614 billion EM sovereign debt market, reported Bank of America Merrill Lynch in June 2011.
We believe that EM corporate bonds are an increasingly attractive asset class, and that the market for these bonds is evolving in ways that should be noted when constructing global portfolios. As the Petrobras bond sale suggests, we see demand growing for this asset class, and we expect to see more assets managed against an EM corporate bond index this year, potentially improving liquidity in the sector. Historically, EM bond investing has come with certain risks, including credit, political and legal risks and market volatility. But PIMCO sees improvement in these areas. As more investors benchmark their EM corporate bonds to an index, as we believe they will, we expect to see a decrease in the magnitude of sell offs in times of stress – in other words, we see EM corporate bonds becoming more integral to asset allocation and more long-term holds. Also, PIMCO sees emerging markets as centers of economic dynamism with favorable circumstances for corporations vs. the developed world.
Managing against the index: Room for growth
Over the past two decades, the evolution of EM corporate bonds as an asset class has lagged that of sovereign bonds. For example, a widely used benchmark for EMCBs was not developed until JPMorgan launched the Corporate Emerging Market Bond Index Broad (CEMBI) at the end of 2001, a full eight years after introducing its sovereign-bond benchmark, the Emerging Market Bond Index, which was followed by the Emerging Market Bond Index Global (EMBIG). Figure 1 shows the growth in market values for both the EMBIG and CEMBI over time. The creation of a widely accepted benchmark for EM sovereign bonds was accompanied by a significant growth in investment strategies managed to the EMBIG. Today, investments benchmarked to the EMBIG represent over half of the market value of that index while the total of funds benchmarked to the CEMBI is only about 7% of the market value of the CEMBI, according to JP Morgan. Benchmarked EMCB investing has a long way to go before catching up to where EM sovereign benchmarked investing is today.
Yet, assets benchmarked to the CEMBI are likely to increase substantially in 2012, PIMCO believes. This is an important development for the sector because as more investors benchmark their assets against an index, typically the gap between buyers and sellers of the securities in that index narrows and liquidity improves.
The bid-offer spread, or gap between buyers and sellers, for the CEMBI was 124 basis points at the end of January 2012, compared to 82 bps for sovereign bonds in the EMBIG, according to JP Morgan’s weighted average bids and offers for their indexes. Improved liquidity and accompanying narrower bid-offer spreads should be an important step forward in increased investor acceptance of EM corporate bonds.
PIMCO believes that growth in demand is likely to be driven by global corporate bond investors seeking to add EM corporate bond exposure to their portfolios for diversification and/or additional yield potential in EM countries that generally have stronger fundamentals vs. developed market sovereigns.
The importance of the macro story
As political and credit risk increasingly permeate the sovereign developed market investment landscape, it becomes harder to argue that corporate bond investing in developed markets is a strictly bottom-up process. PIMCO believes in today’s multi-speed world, with many developed markets deleveraging and emerging markets driving economic growth, every investment decision requires a macro overlay – including corporate bonds.
In our view, country risk has been a key factor in EM corporate and quasi-sovereign defaults, especially during sovereign events. In recent years, however, the financial health of many EM countries has improved, potentially reducing country risk. And we believe the long-term macroeconomic outlook for EM countries is now significantly more robust than that for developed countries, potentially providing a strong tailwind for EM corporate bonds and an important foundation for investing in the asset class.
Undiscovered leverage metrics
Turning to company fundamentals, leverage metrics for many EM corporations have been improving as well, as seen in Figure 2. In general, EM corporates have had healthy corporate profits, positive cash flows, low cost structures, and manageable debt profiles, as measured by the more than 100 companies in the CEMBI.
In addition to indicating financial health, debt ratios can help uncover value in corporate bonds. One way involves looking at the ratio between debt and one-year earnings before interest, taxes, depreciation and amortization (EBITDA). A one-to-one ratio between debt and EBITDA counts as one “turn of leverage,” or debt equal to one year’s EBITDA. Figure 3 shows consistently higher spreads (basis points of yield on corporate bonds above yield on a comparable maturity U.S. Treasury) per turn of net leverage on investment grade EM corporate bonds vs. turn of net leverage on investment grade corporate bonds from developed countries. In other words, the yield is potentially more attractive for the leverage that companies are taking vs. their earnings. (On a total return basis, the EM IG asset class as represented by the BofA/ML High Grade Emerging Market Corporate Plus Index outperformed the US IG asset class as represented by the BofA/ML U.S. Corporate Master Index over the same time period for which spreads are calculated in Figure 3.)
Much of the difference in spreads between similarly rated EM investment grade and U.S. investment grade corporate bonds is likely a result of higher sovereign spreads embedded in EM corporate bond spreads. As markets continue to reprice EM sovereign risk to reflect these countries’ stronger balance sheets, economic growth prospects and balance of payments relative to developed markets, we expect a reduction in the portion of EM corporate spreads that are derived from EM sovereign spreads. Thus, over time, we expect that the gap between similarly rated EM and U.S. corporate spreads will be reduced.
Potential for greater stability
In general, emerging market corporate bonds have historically been owned by investors searching for yield potential rather than dedicated exposure to the asset class. As a result, during periods of market volatility, they have often been sold as investor appetite for risk declined. In the near term, we think such periods of global risk aversion will likely affect EM corporate bonds more than their developed market counterparts – although EM corporate bond benchmark investing continues to grow, it has not yet reached a level where the bids from dedicated investors can offset much of the downward pressure on prices during market downturns.
However, PIMCO believes it is only a matter of time before the assets benchmarked to the CEMBI reach the critical mass seen in the EM sovereign bond market and this should help stabilize prices during “risk-off” periods in the future. In general, during periods of market volatility, dedicated investors (those focused on a particular asset class) are likely to be less inclined to sell because selling can increase the risk of tracking error for the dedicated investors relative to the index. (Tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked.)
Conditions ripe
PIMCO believes that EM corporate bonds may offer not only relative value opportunities vs. EM sovereign bonds, but also significant incremental value for investors in global corporate bonds. Compared to EM sovereign bonds, many EM corporates can offer slightly higher credit quality and shorter duration. Although the CEMBI’s yield is nearly equivalent to the EMBIG’s (CEMBI’s yield has been a few basis points greater as of February 22, 2012) the average credit rating of the CEMBI is one-notch higher than that of the EMBIG (Baa2 vs. Baa3 by Moody’s, as of January 31, 2012) while the CEMBI’s duration is 1.4 years shorter, also as of January 31, 2012.
At times, EM corporates may also offer more attractive yields than EM sovereigns. Many investors in EM sovereign bonds, including PIMCO, opportunistically seek to add yield potential to their portfolios when the gap in yield between sovereign bonds and high quality corporates is large. But what about the relative value comparison between EM corporate bonds and developed country corporate bonds? A look at the historical yields of the Baa2-rated CEMBI compared to those of the Baa-rated (also by Moody’s) Barclays Capital Global Aggregate Corporate Index provides a strong argument, in our view. Figure 4 shows that yields on EM corporate bonds were consistently higher and on average 129 bps more than comparably rated developed market corporate bonds during the past six years. The gap widened to as much as 387 bps during the post-Lehman Brothers crisis, and its lowest point was still 47 bps.
In our view, the road ahead for investing in all risk assets is likely to remain bumpy. We also believe, however, that the secular case for focused EM corporate bond investing remains compelling based on the solid macro backdrop for emerging markets as well as the stronger underlying credit fundamentals and higher yields of many EM corporate bond issues relative to similarly rated bonds issued by developed country companies. The rapid rise in benchmarked investing should also help improve the liquidity of EM corporate bonds and may help the asset class to become a more integral part of global corporate bond portfolios.