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Unveiling the Value of Emerging Markets corporate bonds

EM corporate bonds can provide investors with diversification benefits, yield enhancement and direct participation in three significant trends that are fueling a new regime shift: deglobalization, decarbonization and demographics. These bonds are a crucial component of any EM portfolio, offering the potential for substantial benefits. However, fully capitalizing on the extensive range of opportunities requires a well-equipped team and an active, research-driven approach.

06/11/2023
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Authors

Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

Emerging market corporate bonds are often overlooked despite being a powerful contributor to an Emerging Market portfolio. EM corporate bonds offer investors the benefits of higher yields, diversification in return streams, and the ability to participate directly in thematic sector trends and ESG goals.

The perception of corporates as a subordinate to the EM asset class is a legacy view from the early 2000s when they were less than one-sixth the size of the sovereign bond market and were primarily used to generate incremental yield over sovereign bonds. While today that yield advantage still remains, the sub-asset class has since exploded in stature, growing at an annual rate of 21%, to reach $1.11trn as of July 2023. Currently, EM corporates in the commonly used JPMorgan CEMBI Broad Index make up a sprawling, diverse universe with more than 758 issuers domiciled in over 60 countries1. This compares with 160 issuers in the sovereign index (EMBI Global) and just 20 in the local currency index (GBI-EM Global).

By market value, the EM corporate market is now roughly the same size as EMD sovereigns and is only slightly smaller than the US High Yield market. Accounting for off-benchmark issuances, the asset class size is significantly larger, at $2.5trn as of 2023. Not including them as a component of an emerging market debt (EMD) strategy leaves out major drivers of EM economies.

Market cap growth of EMD corporates versus EMD sovereign

Figure 1 Market cap growth of EMD corporates versus EMD sovereign

Source: JP Morgan as of July 31, 2023. Historical growth trend may not continue.

If we may editorialize, it seems to us that one key reason EM corporates have retained a lower profile is due to the EMD-focused managers themselves. It was possible to build prominent books of business focusing primarily on local and hard currency sovereign bonds, with indices to match. This dynamic perhaps led some asset managers to be reluctant to make the investment in personnel required to cover such a wide sub-asset class as EM corporates. As such, certain firms may have been slower in offering widespread access to this sub-asset class.

Despite the underappreciated growth of the asset class, EM  corporates have nonetheless come into their own and they continue to offer a yield advantage as well as diversification benefits to an EM portfolio. On a ratings-adjusted basis, corporate bonds generally offer higher yields than EM sovereign bonds. And due to duration, yield, and investor base differences, the performance of EM corporates is also less correlated to Treasuries than EM sovereigns. The attractive yield pickup and lower correlation to Treasury performance can provide a valuable ballast to EM portfolios.

Of particular note, these same advantages are also at play when compared to their developed market (DM) counterparts: Split between investment grade and high yield, EM corporates offer more yield per year of duration than their DM counterparts and are significantly less correlated to US Treasuries.

Figure 3 EM Corporate bonds still offer a yield pickup compared to similarly rated Sovereign debt

Source: JP Morgan. Past performance is not a guide to future results

The strong linkage between corporates and sovereigns is undeniable, but well-positioned corporates can outperform nonetheless. Companies are highly impacted by the economic and political conditions of the country where they operate, as well as its local laws, domestic banking system and capital markets. For these reasons, there will always be a tight, fundamental connection between corporate bonds and the sovereign where they are domiciled. But it’s important to note that strong, long-term fundamental sector shifts can support corporates even in the face of challenges at the sovereign level. For example, the development of Brazilian beef and wood pulp sectors into being global leaders lifted the credit profiles of the producers over the past 10+ years. Meanwhile, the Brazil sovereign credit quality – for separate reasons – went the other direction, deteriorating from a strong investment grade rating in 2012 to a BB rating today.

EM corporates also dovetail well with the macroeconomic and geopolitical realities of a post-Global Financial Crisis, post-Covid world. We refer to this scenario as the 3D Reset, and three of the major trends we see helping to drive this new geopolitical and macroeconomic environment include:

  • Deglobalization – Covid, the war in Ukraine and on-going geopolitical tensions have led corporations to realize the vulnerability of their supply chains. According to the OECD, emerging markets (even excluding China) represent eight of the top 15 net foreign direct investment destinations. The trend toward nearshoring to move suppliers closer to production is in full  bloom in countries such as Poland, Hungary, Indonesia and Mexico. There is now a higher value being placed on the security of supply chains, and EM corporates offer multiple ways to capitalize on this trend, including direct investment in suppliers as well as infrastructure-related companies.
  • Decarbonization – The direction of travel from major governments and corporations on this topic is clear, and this is not just a DM endeavor. Further, achieving the goal of a less carbon intensive world will necessarily require significant amount of raw materials that are plentiful within emerging markets. EM corporate opportunities abound, from clean energy suppliers to even utilities with responsible decarbonization plans.
  • Demographics – Declining populations, especially in developed markets, should force technological innovation to further increase productivity. We believe the componentry of many such innovations – including semiconductor chips and automation systems – will be driven by EM companies.

In the pages below, we take the opportunity to highlight examples of these three “Ds” within EM corporates.

Deglobalization

As the advent of multi-polar geopolitics reshapes the global economy, Mexico stands to be one of the clear winners. Multinational companies looking to diversify and strengthen their supply chains against tariff wars and supply-chain bottlenecks are investing into manufacturing capabilities in Mexico. If fully realized, Morgan Stanley estimates exports could rise by up to $155bn over the next five years2. In particular, manufacturing hubs in Northern Mexico are booming: Nearshoring demand for industrial real estate reached a record high of 40% in 1Q22, almost doubling from 21% in 20213.Given the surge in demand, industrial real estate is currently close to sold out in northern areas like Juarez, Reynosa, and Monterrey. Tesla’s decision to build a $5bn plant in Monterrey, or LEGO’s plan for a $500mm expansion, are some of the many key investments being made in the region.

EM corporates offer investors the ability to play this long-term, secular trend by investing in Mexican fibras ( REIT equivalent). Mexican fibras are reporting surging demand for their industrial real estate portfolios with buildings that are sold out before construction has begun, leading to very high occupancy rates, and consequently strong income and healthy portfolios. Investment grade fibra bonds generically offer a significant spread above the sovereign, and are a direct way for fixed income investors to play this massive and meaningful shift in global supply chains. Sovereign cash bonds are unlikely to be as impacted by this trend given the country is already investment-grade rated and with spreads to match.

Figure 5 Mexican industrial areas are sold out

Decarbonization

A number of EM countries have meaningful targets to transform their energy matrices and carbon footprint. Chile’s president Boric made climate change a top priority in his 2021 campaign and in June 2022, Chile published its Climate Change law making the 2050 carbon neutrality target and the Nationally Determined Contribution (NDC) targets binding in law. At COP 26, Chile presented a strategy with over 400 measures to reduce emissions, most prominently the supply of 80% of the energy mix from renewables in 2030.

Given these ambitious targets, investor support is critical. Various Chile corporate bonds offer investors the ability to support Chile’s transition to a greener energy matrix whether through utility companies with ambitious decarbonization plans or infrastructure bonds that are critical to connect renewable energy generation facilities to demand centers.

Given its large population and economy, India is another place where EM corporate investors can make an impact in helping reduce global emissions by supporting the building of renewable power generation and infrastructure. India is a world leader in new renewable energy (“RE”) capacity and generation (excluding hydro), often placing fourth after China, the USA and Germany.

As of March 2023, India had installed more than 125 GW of new RE capacity, bringing renewables to 30% of total capacity, up from 14%. About half of its solar capacity has been installed in just the last three years. EM corporate investors can help fund the building of renewable energy capacity with 15 different issuers in the JP Morgan CEMBI Broad Index funding wind, solar, and hydro generation facilities, or holding company investments into renewable companies. The market cap of these opportunities has grown 4.9x in the CEMBI Broad from early 2018 to today.

Figure 7 India has been growing its share of renewables

Demographics

In developed markets especially, and even in some EM countries, declining demographics are likely to increase competition for the pool of talent, and drive the need for increased automation and productivity enhancing solutions. This is especially the case as the “deflationary dividend” over recent decades from low cost Chinese production has seemed to run its course. While developed markets are clear leaders in technological innovation, emerging markets will pay a key role in supplying their componentry or the systems underpinning such advancements.

Much of the technology and devices depend on powerhouse companies in emerging markets that for instance produce semiconductors and memory chips like TSMC in Taiwan and SK Hynix in South Korea. These companies dominate their respective industries, and will benefit from the soaring demand for artificial intelligence.

Figure 9 TSMC dominates the semiconductor foundry market

Source: TrendForce

Conclusion

Offering diversification benefits, yield enhancement, and the ability to directly play in secular themes, EM corporates are an important tool for any EM portfolio. Exploiting the large opportunity set requires a well-equipped team and a taste for adventure, and in return offers great benefits for investors.

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1 JP Morgan (CEMBI Broad Index)

2 MS_Print Design Latin America Insight English

3 Mexico Equity Strategy: DEEP DIVE: Nearshoring Opportunity Could Add $80-170 bn in Exports or 1.2-2.6pp to GDP per Year

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Authors

Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

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