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1 Viewpoints September 2012 Large and broadly diversified market encompassing 39 countries and 352 issuers Fast-growing asset class now larger than the U.S. high yield bond market Generally higher yields than comparable corporate issuers in developed markets Improving credit quality with three-quarters of all issuers carrying investment-grade ratings Access to growing economies in Latin America, Asia and the Middle East Diversification away from sovereign debt and localcurrency bonds Emerging markets corporate debt: a maturing asset class In recent years, emerging markets corporate debt has become a driving force in the fixed-income markets of developing nations as the sector has grown into a large, broadly diversified universe of investment grade and high yield securities. The EM corporate market is primarily dollar-denominated, allowing investors to mitigate most of the currency risk. And, importantly, the bonds typically offer significantly higher yields than comparable debt issued by companies in developed nations. While the liquidity premium comes with some unique sovereign- and credit-specific risks, experienced investors can seek to reduce those risks through robust global credit research. The result can be a dollar-denominated corporate bond portfolio, broadly diversified across countries and industries, that can capture the growth and improving credit profile of a broad range of corporate issuers. Although generally less familiar to investors than emerging markets sovereign debt, EM corporate bonds are coming to market at more than double the pace of their sovereign counterparts. In the past two years, corporate debt issuance in the emerging markets has increased to $398 billion, compared to $172 billion in sovereign issues. That trend has accelerated in the face of the European sovereign debt crisis, as global investors seek alternative sources of attractive yields and issuers seek stable sources of funding. Higher yields are also the result of an inefficient marketplace with relatively few investors compared to long-established asset classes. In fact, the primary benchmark the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified has only existed since November Viewpoints is a publication exclusively for institutional prospects, clients and consultants.

2 Size and quality of the investable universe The investing environment for EM corporate debt has significantly changed during the past few years as it has matured into a truly diversified marketplace. The emerging markets corporate sector is now larger than the U.S. high yield bond market, in terms of total outstanding debt. Additionally, the credit quality of EM corporates is improving: about three-quarters of the universe is investment grade with many EM corporate debt issues rated double-a or single-a by Moody s and Standard & Poor s. The investable universe includes 352 issuers, seven major industries and 39 countries, including strong economic growth engines in Latin America (Brazil, Mexico), Asia (Hong Kong, South Korea) and the Middle East (Qatar, Saudi Arabia). Many of the corporate issuers are large, well-known global companies such as Hong Kong conglomerate Hutchison Whampoa, Mexican telecommunications provider América Móvil, and Russian natural gas producer Gazprom. Within the EM corporate debt universe, financial and industrial companies dominate the index, followed by oil and telecom. The countries with the largest amount of issuance are China, Russia and Brazil. One prominent issuer, Brazilian oil company Petrobras, sold a record-high $7 billion of corporate bonds in February the largest dollar-denominated offering ever completed by a company based outside the developed markets of the U.S., Europe and Japan. Investor demand for that transaction serves as a milestone in EM corporate debt and bodes well for the growing acceptance of the marketplace among all types of investors. Figure 1: Growth of EM corporate sector 1 and U.S. high yield sector 2 US$ trillion $1.5 External EM corporate debt U.S. high yield debt J.P. Morgan launches CEMBI 3 $1.0 $0.5 $ Source for external corporate debt: BofA Merrill Lynch Global Research, BIS data as of 09/30/11. 2 Source for U.S. high yield debt: Credit Suisse as of 12/31/11. 3 J.P. Morgan launched the CEMBI index on November 8,

3 Dollar is king Dollar-denominated bonds are the vehicle of choice for corporate borrowers in the emerging markets. Registering just $10 billion of issuance in the year 2000, the market has grown dramatically over the years reaching $93 billion by 2005, $153 billion by 2007 and a record-high $210 billion in The corporate market surpassed dollar sovereign debt issuance in 2003 and its growth has continued to accelerate. Although the market began with large, quasi-sovereign entities as the largest borrowers, the recent growth has come from companies with little or no government ownership. Holding dollar-denominated bonds allows investors to reduce currency risk, providing a better asset/liability match and/or avoiding high capital charges, while avoiding the biggest driver of total-return volatility. This important aspect of the EM corporate bond market gives investors a pure vehicle to seek to tap into the growth dynamics of emerging markets, without the threat of local monetary policy actions potentially hurting returns through currency devaluation or local yield curve movements. Conversely, of course, these bonds do not participate in gains when a local currency appreciates against the dollar. Essentially, issuing debt in U.S. dollars makes the market more attractive to a larger universe of investors who might want exposure to attractive national or multinational companies domiciled in EM countries, yet without gaining exposure or having the expertise to manage currency risks in the Russian ruble, the South African rand or the Indonesian rupiah. Figure 2: Rating exposure total indices J.P. Morgan CEMBI Broad Diversified Investment Grade and J.P. Morgan CEMBI Broad Diversified as of June 30, 2012 CEMBI IG CEMBI AA & above A BBB BB & below Rating % CEMBI IG % CEMBI AAA AA A BBB BB 12.8 B 9.4 CCC & below 0.1 Unrated Total CEMBI IG reflects J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified Investment Grade. CEMBI reflects J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified. Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor s, and Moody s, as an indication of an issuer s creditworthiness. Securities in the Unrated category have not been rated by a rating agency. Totals may not reconcile due to rounding. 3

4 Liquidity premium Even with continually improving credit fundamentals, EM corporate bond issuers continue to offer significant premiums over comparable debt issued by companies in fully developed nations. The yield on the J.P. Morgan CEMBI Broad Index is 5.58% (as of 6/30/12) with the high yield component of this index yielding over 8.6% (Figure 4). That is approximately 257 basis points above the Barclays U.S. Credit index and 420 basis points above 10-year U.S. Treasury securities. Much of this yield differential is essentially a liquidity premium which compensates investors for the additional risks associated with investing in emerging markets and evolving acceptance of the asset class. Clearly, the hunt for yield is a primary reason that investors are increasingly drawn to EM corporate debt. But there are many other positive attributes, including: the opportunity to participate in the rapid economic growth of emerging market nations; diversification away from sovereign debt and local currency risk; as well as the opportunity to diversify away from developed nations, many of which are struggling with high debt levels and slow economic growth. The growing recognition of developing nations low indebtedness, improving credit fundamentals, attractive demographics and a commitment to monetary and policy reform has helped to mitigate concerns about the risks of venturing into emerging markets. As a result, the sector is rapidly becoming a key strategic holding for an expanding circle of institutional and insurance-related investors. Trading places Capital trader Brian Klingenberg says the rapid growth of emerging markets corporate debt has produced interesting new trends over the past two years: A vibrant new-issue market where corporate offerings across the ratings spectrum are met with strong demand from investors. Unlike the recent past, market participants can absorb large issues with a wide variation in credit quality. Greater availability of debt maturities, including long-dated bonds. It is no longer just a 5- and 10-year maturity market. It has a full yield curve available in many industries. The emergence and importance of the cross-over buyer high grade or high yield bond investors looking for greater exposure to emerging markets. This trend has helped improve market liquidity. A maturing corporate bond market that does not move entirely in lock-step with the sovereign market. There is noticeable separation. 4

5 Unique risks Issuing in dollar-denominated bonds reduces currency risk for U.S. investors, but that is just one part of the risk equation in EM corporate debt. Investors need to understand that the sector comes with a unique set of risks, not all of which can be entirely eliminated. Sovereign and political risk are ever present in the emerging markets and serve as another reason why yields tend to be higher than they otherwise would be, based on credit quality alone. Nevertheless, sovereign risk is less influential in EM corporate bond valuations and company-specific credit risk has become the key driver. The key to mitigating these risks is global credit research. Taking a global approach to researching emerging markets companies is paramount, so that industry analysts are capable of recognizing the relative value of a Petrobras versus a Chevron, a Braskem versus a Dow Chemical, or a Vale versus a Rio Tinto. As sovereign risk premiums continue to decline in the emerging markets, credit risk is accounting for an increasingly larger portion of total return placing greater importance on analysis of credit fundamentals and a global relative-value approach, overlaid by macro and political analysis. Tapping into deep global research is crucial, whether it is part of a dedicated emerging markets investment strategy or a broader worldwide strategy. The same criteria, experience and knowledge apply across all strategies where EM credit is a part of the opportunity set. Hunt for yield The relatively attractive yields offered by emerging markets corporate debt can be demonstrated by looking at two competing companies: TransOcean, based in the United States, and Brazil s Odebrecht Oil & Gas. Both are leaders in the offshore oil drilling industry and both carry triple-b debt ratings. But Odebrecht s 10-year notes trade at about 375 basis points above U.S. Treasuries, while comparable notes from TransOcean trade at 225 basis points over (as of 7/31/12). At a time when Treasuries are hovering below 2%, bond investors are increasingly finding alternative sources of yield among corporate issuers based in faster-growing emerging markets. Figure 3: Ten largest issuers in CEMBI As of June 30, 2012 Issuer Country % CEMBI IG % CEMBI América Móvil Mexico Hutchison Whampoa Hong Kong TAQA UAE RasGas Qatar Digicel Jamaica 1.7 Issuer Country % CEMBI IG % CEMBI DBS Group Holdings Singapore Qtel International Finance Qatar Petrobras Brazil Gazprom Russia Southern Copper Peru CEMBI IG reflects J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified Investment Grade. CEMBI reflects J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified. 5

6 Respectable returns As one might expect, where there is risk, there must also be the opportunity for attractive returns. Historically speaking, that has certainly been the case for EM corporate debt, which has compared favorably over most time periods to investmentgrade U.S. corporate bonds and U.S. high yield bonds (see chart below). The J.P. Morgan CEMBI Broad Diversified posted average annual total returns of 5.6%, 16.5%, and 7.0% over one-, three- and five-year time periods, respectively, for the period ending March 31, The five-year period includes the 2008 global credit crisis, when EM corporate bonds took a major hit, declining 15.9% for the year. But by the end of 2009, EM corporates showed their resiliency by bouncing back with a return of 34.9%. These are respectable results for an area of the market that was barely on investors radar screens just a few years ago. Given the benefits of a large and highly diversified investable universe, widely available in dollar-denominated bonds and offering a significant yield premium, emerging markets corporate debt clearly offers investors a substantial opportunity for attractive returns. Figure 4: Sector spreads as of June 30, 2012 Spread (bps) 2,000 Emerging markets debt 1 U.S. high yield 2 1,600 J.P. Morgan launches CEMBI 3 Emerging markets corporate debt 3 U.S. credit 4 1, J.P. Morgan EMBI Global. 2 Barclays U.S. High-Yield Index, 2% Issuer Cap. 3 J.P. Morgan CEMBI, launched on November 8, Barclays U.S. Credit Index. Past results are not predictive of results in future periods. The statements expressed herein are informed opinions, are as of the date published, and are subject to change at any time based on market or other conditions. This publication is intended merely to highlight issues and is not intended to be comprehensive or to provide advice. Permission is given for personal use only. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited. Securities offered through American Funds Distributors, Inc., member FINRA 09/ Capital Group Institutional Investment Services The Capital Group Companies American Funds Capital Research and Management Capital International Capital Guardian Capital Bank and Trust 6

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