{"id":25257,"date":"2012-10-15T00:20:00","date_gmt":"2012-10-14T22:20:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/corporate-bonds-ideal-for-emerging-markets-diversification\/"},"modified":"2019-12-30T22:27:28","modified_gmt":"2019-12-30T21:27:28","slug":"corporate-bonds-ideal-for-emerging-markets-diversification","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/corporate-bonds-ideal-for-emerging-markets-diversification\/","title":{"rendered":"Corporate Bonds \u2013 Ideal for Emerging Markets diversification"},"content":{"rendered":"

Background of the asset class<\/strong><\/p>\n

Corporate bonds have an attractive long-term risk\/return
\nprofile. Historically the asset class generates returns
\nsomewhere between equities and sovereigns but, in the
\npast five (albeit exceptional) years and in a favourable
\nenvironment of global deleveraging, it has far outperformed
\nequities. Corporates are a long-established asset
\nclass in the US where they are the mainstay of many
\npension funds and the asset class is expanding rapidly.
\nPost credit crunch, many companies have turned to the
\ncredit markets rather than the banks for funding. Thus it
\nis that Emerging Markets corporates has grown into an
\nasset class of its own.<\/p>\n

In the Emerging Markets, credit markets are maturing just
\nas rapidly as stock markets. Not only do EM corporates
\noffer attractive diversification away from EM sovereigns
\nand equities, they also currently offer very attractive
\nreturn potential, compared with their US counterparts.
\nAs the chart below shows, EM corporates are paying
\nmore per unit of risk than US corporates across much
\nof the credit spectrum. With the High Yield credit premium
\nat 800 basis points and Investment Grade at 250 basis points, the willingness of investors to settle for
\nhistorically low or negative interest rates from US and
\nEuropean \u2018safe\u2019 sovereign bonds is all the more surprising.<\/p>\n

\"Spread
Spread per Turn of Net Leverage<\/figcaption><\/figure>\n

What makes these risk premia all the more attractive is
\nthe fact that default risk is lower on average in Emerging
\nMarket nations because of the corporate tradition of
\nkeeping debt levels low and cash levels high. The higher
\ncash buffers in EM companies will also help them to
\nwithstand recession better and invest for growth as the
\nrecession ends.<\/p>\n

Investment opportunities in EM bonds<\/strong><\/p>\n

As markets begin to mature and companies are able to
\ndemonstrate a history of debt repayment and creditorfriendly
\nbehaviour, so a value approach to corporate
\nbond investment becomes possible. As with value equity
\ninvestment, value bond investment means looking for
\npricing inefficiencies in the markets and investing with a \u2018margin of safety\u2019 which hinges on a low net-debt-toequity
\nratio. Experience has shown that value and smallcap
\nbonds in companies with low debts generate excess
\nreturns and therefore represent an identifiable alpha
\nfactor in the credit universe. This effect can be amplified
\nin Emerging Markets. For example, we frequently find
\nexamples of smaller companies and value companies
\nthat are penalised by rating agencies for reasons totally
\nunrelated to their ability to repay their debts. Also, the
\n\u2018sovereign ceiling\u2019 effect has, in the past, meant that for
\nsome emerging market corporates, ratings are marked
\nlower simply on grounds of the company\u2019s head-office
\nlocation. However, given that Developed Countries\u2019 sovereign
\nratings seem to be on a negative trend – whereas
\nwe still expect positive rating actions among EM sovereigns we would expect future convergence between
\nthe average ratings of the more mature Emerging Market
\ncountries with Developed Market countries.<\/p>\n

A value approach to corporate bonds seeks to identify
\n\u2018overlooked\u2019 and under-rated companies that are forced
\nto pay high yields while offering solid business models
\nor assets or cash backing as a margin of safety for debt
\nrepayments.<\/p>\n

Integrating SRI\/corporate governance information<\/strong><\/p>\n

SRI and corporate governance insight is as important
\nto fixed income investors as it is to long-term equity
\ninvestors because any risk that might erode a company\u2019s
\nfuture profitability is also a threat to its capacity to repay
\ndebts. Corporate governance is known to be weaker
\nin Emerging Market companies – although it is improving
\n\u2013 and this is one of the reasons that EM corporates
\nneed to pay higher yields. Thus a thorough analysis of
\ncorporate governance should be included as an essential
\nstep in the corporate bonds investment process. Failure
\nto consider environmental, social and governance risks
\ncan expose investors to large \u2018tail risk\u2019 like litigation risk
\nor the risk of large lawsuits arising from \u2013 for example \u2013
\nenvironmental disasters. Rule of law and property rights
\nare also an important consideration. For example the
\nMongolian Government has made a \u2018National List\u2019 of
\nresources and sectors of strategic importance. This type
\nof action could end up in assets being expropriated from
\ncompanies\u2013 which may involve a significant headline risk
\nfor their debt holders.<\/p>\n

What is the outlook for EM corporate bonds?<\/strong><\/p>\n

The pace of economic growth has been slowing in the
\nemerging market economies. But this is potentially good
\nnews for credit investors. For a start, the extreme pace
\nof economic growth was starting to cause problems for
\ncompanies – such as increasing salary costs, increasing
\ninflation affecting raw material prices and decreasing
\nglobal competitiveness. But in general, lower growth
\nscenarios favour corporate bond investors because
\nthey force companies to focus on profitability and
\ncareful, organic growth rather than on leveraging up
\ntheir balance sheets and taking risks. For these reasons
\nand because of the strong cash levels in EM corporates,
\nwe expect the default rate, which is already lower
\non average than in developed markets over the past
\ndecade to retain that advantage over the coming years.<\/p>\n

\"Default
Default Rate<\/figcaption><\/figure>