Emerging Market Corporate Bonds: Rising in prominence and broadening investment opportunities

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1 T. Rowe Price Ivestmet dialogue Emergig Market Corporate Bods: Risig i promiece ad broadeig ivestmet opportuities Mike Coelius, CFA, Portfolio Maager Executive Summary Emergig market (EM) corporate bods are takig a more promiet role i fixed icome portfolios, as emergig ecoomies have reduced sovereig debt i recet years. Ivestors may cosider EM corporate bods either as a stadaloe asset class or as part of a broader fixed icome strategy. They offer ivestors several beefits, icludig a attractive yield, higher credit quality ratigs relative to EM sovereig ad high yield debt, ad attractive returs. The asset class cotiues to evolve, but ogoig market liquidity improvemets ad stregtheig credit fudametals are providig the foudatios for it beig a itegral part of the fixed icome uiverse, as well as helpig to mitigate ivestmet risks. A broader ad deeper market icreases the complexity of the asset class ad argues for a more sophisticated skill set. A itegrated research approach is essetial to idetify potetial opportuities, combiig the disciplies of credit, sovereig ad equity aalyses. Corporate bods i emergig markets provide ivestors with the opportuity to express a rage of macro themes, whilst at the same time takig advatage of a improvig credit story. I particular, as the global ecoomy rebalaces, corporate bods are cosidered oe of the best fixed icome opportuities to reflect a positive ivestmet view o the domestic-demad recovery theme i emergig coutries. Emergig market (EM) corporate bods are takig a more promiet role i fixed icome portfolios, as ecoomies have reduced sovereig debt i recet years. They offer ivestors several beefits, icludig a attractive yield, higher credit quality ratigs relative to EM sovereig ad high yield debt, ad attractive returs. It cotiues to be a evolvig asset class. However, ogoig market liquidity improvemets ad stregtheig credit fudametals provide the foudatios for this asset class beig a itegral part of the fixed icome uiverse. These developmets are also helpig to mitigate ivestmet risks. Noetheless, the broadeig ad deepeig of the asset class also icreases its complexity ad supports the argumet for a more sophisticated ivestor skill set. We believe that a itegrated research approach is essetial to idetify potetial ivestmet opportuities, combiig the disciplies of credit, sovereig ad equity aalyses. Beefits of EM corporate bods There are a umber of beefits to ivestig i EM corporate bods either as a stadaloe strategy or withi a broader emergig markets debt portfolio. The asset class offer ivestors: a attractive yield (5.94% ); 1 a higher average credit quality ratig (BBB-) relative to EM sovereig ad high yield debt; ad attractive returs. While performace history is relatively short for this evolvig asset class, over oe- ad three-year time periods EM corporate bods have outperformed EM sovereig hard currecy debt, global ivestmet-grade corporate bods, ad U.S. ivestmetgrade corporate bods (see Figure 1, page 2). High yield bods outperformed EM corporate bods over those periods but with a higher risk profile over the three-year period. The key idex characteristics are show i Figure 2 o page 2. Historically, corporate bods i emergig markets have bee clouded by perceptios of illiquidity ad high risk. However, these cocers are recedig. Liquidity withi the asset class has improved 1 J.P. Morga s Corporate Emergig Market Bod Idex Broad Diversified

2 sigificatly. I 21 aloe, the market capitalizatio of the J.P. Morga Corporate Emergig Markets Bod Idex Broad (CEMBI Broad) icreased by 44% ($344 billio compared with $289 billio at the ed of 29). 2 The expasio of the asset class is leadig to greater regioal ad sector diversity Lati (see America Figures 3 ad ). At the start of the milleium aroud half of Middle all ew East issuace origiated i Lati America. By Europe , the regio s share of corporate ew issuace declied to Africa 3.34 aroud oe-third. 3 There has bee a marked icrease of other regios market share of corporate issuace over this period, i particular emergig Europe ad Africa ad the Middle East. Figure 1: Aualized Returs i USD 1 Year (%) 3 Year (%) 5 Year (%) EM Corporate Hard Currecy Aualized Risk EM Sovereig Hard Currecy Aualized Risk High Yield Aualized Risk Baks Global Ivestmet-Grade Idustrials Corporate Bods Telecom (USD hedged) Aualized Risk Oil Utilities 1.3 U.S. Ivestmet-Grade Metals & miig Corporate Bods Cosumer Products 3.4 Aualized Risk U.S. Treasuries Aualized Risk Represetative idices iclude J.P. Morga Corporate Emergig Markets Bod Idex Broad Diversified (EM Corporate Hard Currecy), J.P. Morga Emergig Markets Bod Idex Global (EM Sovereig), J.P. Morga Global High Yield, Barclays Global Aggregate Corporate Idex USD Hedged (Global Ivestmet-Grade Corporate Bods) ad Barclays U.S. Ivestmet Grade Corporate Idex (U.S. Ivestmet-Grade Corporate Bods). U.S. Treasuries are represeted by the U.S. Treasury compoet of the Barclays U.S. Govermet Idex. Sources: J.P. Morga, Barclays Capital I 2, the combied share of corporate issuace i both regios was 14% (9% i emergig Europe ad 5% i Africa ad the Middle East). 4 This combied share climbed to 33% i 29 (18% i emergig Europe ad 15% i Africa ad the Middle East). Figure 3: J.P. Morga CEMBI Broad Diversified Regioal Diversificatio 16.6% 13.4% 26.9% Source: J.P. Morga 3.3% 39.8% Figure 4: J.P. Morga CEMBI Broad Diversified Sector Diversificatio 12.% 1.3% 12.6% 6.8% Source: J.P. Morga 3.4% 21.3% 33.5% Lati America Middle East Europe Africa Baks Idustrials Telecom Oil Utilities Metals & Miig Cosumer Products Figure 2: EM Corporate Bods: Idex Characteristics 2 J.P. Morga, Emergig Markets Outlook & Strategy for 211, 6 Ja J.P. Morga, EM Corporates Emerge as a Asset Class, March ibid. Yield (%) Duratio (Years) Spread (bps) Average Credit Quality Average Maturity Total Market Value ($) EM Corporate BBB b EM Sovereig BB ,264 b High Yield B 6.7 1,68 b Global Ivestmet-Grade Corporate Bods A/A- 8. 6,54 b U.S. Ivestmet-Grade Corporate Bods A 1.2 2,843 b Represetative idices iclude J.P. Morga Corporate Emergig Markets Bod Idex Broad Diversified (EM Corporate Hard Currecy), J.P. Morga Emergig Markets Bod Idex Global (EM Sovereig), J.P. Morga Global High Yield, Barclays Global Aggregate Corporate Idex USD Hedged (Global Corporate Bods) ad Barclays U.S. Ivestmet Grade Corporate Idex (U.S. Ivestmet-Grade Corporate Bods). Sources: J.P. Morga, Barclays Capital 2 t. rowe price

3 From a sector perspective, baks remai the largest sector i the overall corporate bod market, but eergy ad telecom compaies have expaded their market share i recet years. Corporate bods i emergig markets also ted to have a higher credit quality ratig relative to other higher-yieldig fixed icome asset classes. Nearly 7% of J. P. Morga s CEMBI Broad Diversified is rated ivestmet grade (see Figure 5). Figure 5: J.P. Morga CEMBI Broad Diversified Credit Quality Diversificatio 15.2% 1.2% 7.1% vereig EM Corporate Source: J.P. Morga Positive supply/demad treds % Ivestmet Grade Favorable supply ad demad treds over the past 18 moths have beefited the EM corporate bod asset class, ad positive techical coditios are expected to cotiue. 21 saw a strog revival i the ew issue market, which totaled $211 billio for the full year. 5 Low iterest rates ad a pickup i global credit activity helped the market toward a robust recovery followig the Corporate primary market s cotractio i 28. Hitherto, the EM corporate bod market had experieced rapid growth with ew issuace levels icreasig from $19.7 billio i 2 to $153.2 billio i 27 (see Figure 6). 6 Several log-term factors had fueled the market s growth over that period, icludig reduced exteral sovereig debt issuace, a broadeig ad stable ivestor base, bechmark developmets, 7 ad fiacial ad ecoomic reforms. ig frica Noetheless sice 28, the fiacial crisis has provided aother spur to the growth of the EM corporate market. Tighter credit coditios ad the withdrawal of bak ledig have ecouraged corporatios i emergig markets to tap the iteratioal capital markets for their fiacig eeds. Curret EM corporate ew issuace amply exceeds EM sovereig issuace ad this tred is forecast to cotiue (see Figures 6 ad 7). BB B Residual As well as the opeig of iteratioal credit lies to corporatios i emergig markets, there appears to be a ogoig structural shift i ivestor allocatios from EM sovereigs to EM corporate bods. Buoyat demad for ew corporate supply i 29 ad 21 has bee stimulated by low iterest rates i developed markets as ivestors hut for yield. I the secod half of 21, ivestor iflows ito emergig market fixed icome assets averaged $6 billio a moth, with a large proportio directed toward emergig market corporate debt. 8 J.P. Morga otes that assets uder maagemet bechmarked to the CEMBI Idex Family more tha doubled i 21 (to U.S.$15 billio as of Residual October 21), idicatig that allocatio shifts ito EM corporate bods remai sustaiable. 9 Moreover, ivestors risk BB appetite for EM corporate bods has bee supported by the sigificat improvemet i corporate credit Ivestmet Grade fudametals over the last 12 moths. The global default rate for ($ Billios) Figure 6: Exteral Debt New Issuace: EM Corporate Versus EM Sovereig $ Billios 2 EM Sovereig 18 EM Corporate B F Figure 7: Exteral Debt Issuace Forecast: Sources: J.P. Morga ad Bloomberg EM Corporate Versus EM Sovereig Market $ Billios 3 EM Sovereig EM Corporate % ($ Billios) Europe Sources: J.P. Morga, Bloomberg Lati America Middle East/ Africa -2 5 J.P. Morga, Emergig Markets Outlook & Strategy for 211, 6 Ja J.P. Morga, EM Corporates Emerge as a Asset Class, March J.P. Morga Corporate Emergig Markets Bod Idex was itroduced i Dec J.P. Morga, Emergig Markets Corporate Outlook & Strategy for 211, 1 Dec ibid. Europe Lati America Middle East/Africa T. ROWE PRICE 3

4 high yield bods fell sharply i 21 followig a spike i levels i 29 (see Figure 8). Withi the EM corporate bod uiverse, the high yield EM corporate default rate is expected to fall to 1.3% i 21. For the EM corporate market as a whole, the ratio of upgrades exceeds dowgrades (1.7x i the year to date). 1 Ogoig improvemets to credit fudametals are expected to cotiue ito 211 based o evidece of decliig et leverage ratios, risig cash flow levels ad icreasig EBITDA levels. 11 Figure 8: 12-Moth Rollig Default Rate 12% JPM Global HY Idex HY Log-Term Average of 4.47% Dec-5 Mar-6 Ju-6 Sep-6 Dec-6 Mar-7 Ju-7 Sources: J.P. Morga, T. Rowe Price Sep-7 Dec-7 Mar-8 Ju-8 Sep-8 Dec-8 Mar-9 Ju-9 Sep-9 Dec-9 Mar-1 Ju-1 Sep-1 Dec-1 The surge i corporate bod market issuace, ad resultat growth i market size ad icreasig diversity, is a reflectio of the broad rage of opportuities available withi the asset class. Noetheless, these treds also sigal the icreasig complexity of Dec-5 the Mar-6 asset Ju-6 Sep-6 class Dec-6 Mar-7 ad Ju-7 argue Sep-7 Dec-7 for Mar-8 a Ju-8 more Sep-8 Dec-8 sophisticated Mar-9 Ju-9 Sep-9 Dec-9 Mar-1 ivestor Ju-1 Sep-1 skill set. A itegrated research approach A distict feature of emergig market corporate bods is the Dec-1 compositio of the yield spread risk premium, which comprises both corporate ad sovereig risk. Cosequetly, corporate bod aalysis i emergig markets eeds to be multidiscipliary. A itegrated research approach is achieved by combiig credit metric aalysis with fudametal macroecoomic aalysis. There is also a third dimesio: the equity perspective. This provides a extremely valuable view from a differet part of the capital structure. The ability to triagulate the credit, sovereig ad equity perspectives provides a holistic view, leadig to thorough ad rigorous aalyses. From a microecoomic perspective, a ivestor will aalyze a variety of factors, icludig: the level of compay idebtedess ad its appropriateess relative to compay or sector operatig risks; bod coveats (such as limits o leverage, asset pledges or chages of cotrol); capital expediture plas; ad the likelihood of exteral fudig requiremets HY Log Term Average of 4.47 Qualitative JPM aalysis Global HY is Idex equally importat to quatitative aalysis, ad face-to-face compay meetigs are a essetial part of the due diligece work. Corporate trasparecy i emergig markets ca be limited compared with developed markets. Accoutacy stadards may be less uiform ad there ca be cosiderable delay i publishig fiacial reports. Thus, a aalyst ca gai tremedous isight ito the ivestmet merits of a compay whe meetig with the CEO. Moreover, skilful ivestors are also those who are able to take advatage of the sovereig risk premium, while at the same time capturig a improvig credit story. Sovereig risk has a sigificat ifluece o compay risk i emergig markets. Moody s foud that early three-quarters of emergig market corporate or subsovereig defaults occurred durig a sovereig crisis betwee 1995 ad May emergig market credits trade i setimet with their related sovereig debt, particularly as they ted to beefit from direct ad idirect state support. I cosequece, sovereig risk presets ivestors with potetial opportuities. Macroecoomic factors prospects for GDP expasio, iflatio, employmet ad cosumptio are ifused with the microecoomic perspective to help corporate bod aalysts formulate their ivestmet views. For example, whe assessig the credit metrics of a Ukraiia-based thermal coal producer, the EM corporate credit aalyst would seek the sovereig aalyst s opiio o demad for electrical eergy i the Ukraie. The credit aalyst would also receive guidace o broader fiscal issues. 1 J.P. Morga, Emergig Markets Corporate Outlook & Strategy for 211, 1 Dec ibid. Based o J.P. Morga s aalysis of a sample set of 13 compaies withi the CEMBI Broad. 12 Emergig Market Corporate ad Subsovereig Defaults ad Sovereig Crises: Perspectives o Coutry Risk, Moody s Ivestors Service, Feb t. rowe price

5 Sice the Ukraie has secured IMF fudig, the credit ad the sovereig aalysts would assess the coutry s ability to meet fiscal obligatios ad the potetial for a coutry ratig upgrade ultimately, a ratigs agecy upgrade of the sovereig may beefit the credit ratig of the corporate bods based i that coutry. Capturig log-term opportuities Supported by a itegrated research approach, corporate bods i emergig markets provide ivestors with a tool to express a rage of macroecoomic themes, whilst at the same time takig advatage of a improvig credit story. As the global ecoomy rebalaces, corporate bods are cosidered oe of the best fixed icome opportuities to reflect a positive ivestmet view o the domestic-demad recovery theme i emergig coutries. Fiscal stimulus measures i several coutries have stregtheed private cosumptio, supportig sectors such as property. I Chia, for example, the govermet has take steps to shift the drivers of growth away from exteral demad toward icreasig domestic cosumptio, icludig subsidies for household appliaces ad automobiles, as well as icreasig social security provisios. Despite the govermet s ear-term desire to cotrol property price appreciatio, a loger-term cosequece of its strategy to icrease domestic cosumptio is the eed for more ifrastructure ad real estate, which should also fid support from strog urbaizatio treds ad risig icomes. Ivestors may capture opportuities i real estate ad buildig compaies i Chia, particularly those exposed to the smaller, less peetrated cities which have ot yet experieced sigificat property price appreciatio. Commodity demad is aother importat theme that ca be exploited through ivestig i EM corporate bods. I particular, compaies withi the eergy sector are otable beeficiaries of icreasig demad from Chia ad Idia. Eergy compaies based i emergig Europe, the Middle East ad Lati America are egotiatig good fiacial terms, accessig ew markets, diversifyig their reveue streams ad ehacig their liquidity profiles to the beefit of existig bodholders. Furthermore, corporate credits ca provide a more accessible path for ivestors to gai coutry exposure, i may cases to frotier emergig markets. Kazakhsta, for example, has a relatively small ad illiquid sovereig debt market. The coutry s ecoomy is stregtheig o a recoverig oil price ad global ecoomy, while foreig direct ivestmet flows are icreasig. Bilateral ledig from Chia is beefitig the ecoomy ad helpig to fud ifrastructure projects i the oil ad gas sector, which comprises 2% of Kazakhsta s ecoomy. Quasi-sovereig issuers i the oil ad gas sector may provide a efficiet way for ivestors to gai exposure to stregtheig coutry fudametals, as well as capturig potetially improvig credit stories. A broader rage of ivestmet choices EM corporate bods provide ivestors with a broader rage of ivestmet choices, allowig ivestors to exploit both credit ad sovereig risk. They are ow a key compoet of the fixed icome uiverse, providig the beefits of a yield premium, a high credit quality ratig ad attractive returs. Ivestors may allocate to the asset class either o a stadaloe basis or through a broader emergig market sovereig debt portfolio or corporate bod portfolio. The icreasig complexity of the asset class argues for a more sophisticated skill set, icludig a itegrated research approach that combies the disciplies of credit, sovereig ad equity aalyses. This approach should allow ivestors to express a rage of ivestmet themes, ultimately addig diversity ad value to their fixed icome portfolios. t. rowe price 5

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