Podcast: Lifting the veil on EM corporate debt

Find out more about this vast asset class and how it's expected to perform against the backdrop of the 3D reset.

10/11/2023
vietnam-emerging-market

Authors

John Mensack
Investment Director, Fixed Income
Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

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You can read a full transcription below:

[00:00:08.810] - John Mensack

I'm, of course, John Mensack, Senior Investment Director, emerging markets and commodities at Schroders. Today's topic, emerging market corporate bonds, which if not currently on your radar, probably ought to be. And of course, there's no one more qualified to speak on this topic than my long-time colleague and emerging market debt portfolio Manager, Autumn Graham. Autumn, how are you today? Hi John, good.

[00:00:32.160] - Autumn Graham

Good to be here.

[00:00:33.980] - John Mensack

Yeah, great to see you. So maybe just a little table setting, if we can. Autumn, can you provide your background for our listeners, please?

[00:00:43.230] - Autumn Graham

Sure. So, I'm a portfolio manager here at Schroders. I've spent my entire career in emerging markets, most of which was in research. I joined the firm about six years ago and then shortly thereafter moved to Portfolio Management. And today I manage our corporate exposures within our emerging market for funds.

[00:01:05.020] - John Mensack

Okay, perfect. Thank you for that. Most podcasts, of course, Autumn, are designed to be like law and order episodes, which is to say they're designed to have a long shelf life and irrespective of the seasons outside. But we would be remiss if we didn't mention that we're recording on Halloween 2023. And I suppose our asset class today is maybe a bit mysterious, but not all that scary. Would you agree?

[00:01:30.810] - Autumn Graham

There is nothing overly spooky about the asset class, I wanted to spell that right away.

[00:01:35.760] - John Mensack

All right, terrific. So what we're going to do then, we got a lot to cover, obviously. Start us off at the kind of the 15,000-foot level. Can you help us dimension the size of the EM corporate sub asset class, and maybe how does this compare to more standard fixed income sub-segments?

[00:01:53.730] - Autumn Graham

Yeah, sure, I would love to do that. I do think the asset class as a whole is a little bit overlooked. So, I think that its size is underappreciated. I think that that is partly a function of the fact that it has just been one of the fastest growing credit segments over the past decades. So, from the early 2000s, EM corporates were only about a 6th of the EM sovereign bond universe, but today they stand at over a trillion outstanding and this is the same size as EM sovereign investable universe, and it's only slightly smaller than US high yield. So again, not as much attention paid to the asset class as you would expect for something of its size.

[00:02:40.130] - John Mensack

Exactly. So, what do EM corporates then bring to a diversified emerging market debt portfolio?

[00:02:48.710] - Autumn Graham

Yeah. So, I think that it can bring a lot of different idiosyncratic sources of return and alpha generation. So, that can be a credit specific story. So a company that is improving its business profile or its capital structure, or perhaps it has a positive event risk. Or alternatively, you can use EM corporates to really turbocharge a more macro call. So, for instance, you may be positive on a particular sovereign. You could buy bank bonds that yield significantly more than that sovereign.

[00:03:26.230] - John Mensack

So also, I would say, Autumn, one of the things we've spoken about in the past is that when there are a lot of flows into the asset classes, sometimes they go into ETFs, which are mostly sovereign only. And the yields that are interesting in the sovereigns tend to get compressed. But you still have corporates and you still have quasi sovereigns that can provide some nice value in those times.

[00:03:50.650] - Autumn Graham

Yeah, that's right. So again, we kind of go back to that dynamic where corporates are slightly under covered, I think, compared to these more traditional credit segments like sovereigns, or maybe even developed market credit. The investor base can be fairly different, so you have participation by local banks, family offices, pension funds, and they'll have different time horizons and return expectations than kind of the large unconstrained global investors who can dominate in either developed market credit or in EM sovereigns. And to your point, ETFs are also a less meaningful presence in EM corporates. So, for all those reasons, sometimes you can get a little of that excess return, more value in corporates compared to sovereigns. It's also interesting to see how those different dynamics can affect performance of the asset class. So, corporates will deliver a different kind of performance compared to sovereigns when you have them both within a portfolio. And we've gone through a couple of examples where you can invest in different stories within corporates, but on an index level basis, corporates tend to yield more, and they have a shorter duration. And so these two characteristics, combined with being a little less liquid and having different investor bases, means that performance is going to be different and they are less correlated with treasuries.

[00:05:22.070] - John Mensack

Okay, terrific. And so what sort of yield pickup, can EM corporates provide relative to the sovereign say, for example?

[00:05:32.010] - Autumn Graham

Yeah, so I think looking at the very top line indices is tricky, because again, there's differences in average ratings and duration. But when you zoom into specific credit buckets, I think that that becomes a little bit more meaningful. So, for instance, when you look at triple B corporates compared to triple B sovereigns, there's a pickup of about 60 basis points. When you look at the rating buckets within the indices, when you go into double B versus sovereigns, there's 100 basis points of pickup in yield. So you do get a nice pickup there. Now again, the EM corporate universe is a big sprawling space. There's over 750 issuers within the index in around 60 different countries, right. So you're going to get a lot of variation within that. But I would say corporate will generally offer 50 to 200 and 250 basis points pickup compared to its similarly rated sovereign curve.

[00:06:42.690] - John Mensack

So one of the things I really enjoy about working at Schroder's, Autumn, and I suspect you do too, is that we don't talk our book here, right. And so, we just lay the facts out and the investors make the decision from there. And I think that's really what they expect of us. So let's talk about refinancing risk in EM. And of course, you've been all over this internally here at Schroder's. Give us a sense of how closed is the refinancing window in EM corporates right now for high yields versus IG. Let's just start there and give us some historical perspective on that, please.

[00:07:23.230] - Autumn Graham

Sure. In today's market, to your point, John, I think we do need to be careful in this environment. Interest rates are high, financing conditions are tight, and it is a situation where a falling tide is going to strand a number of boats. Now, when you separate it by investment grade versus high yield, I would expect the vast, vast majority of investment grade universe to be fine in this environment. Now, they will have a higher cost of debt and through both in the bond market as well as local market funding, given high rates across emerging markets. But these companies overall are very strong, diversified, low leverage and profitable, and they can afford these higher rates. High yield is different. And I think that there's a number of red flags that you can look out for to kind of avoid these trouble spots and avoid the kind of companies that may not make it through this cycle. And so, who are these potentially stranded boats? These are mostly going to be small companies. High yield can often be single bond issuers. These are all kind of red flags. Their bonds will be trading at unaffordably high rates in the secondary market.

[00:08:50.460] - Autumn Graham

So this is indicating that the company has lost access to the bonds market.

[00:08:55.770] - John Mensack

Would that be right now, greater than 12% or greater than what, right now?

[00:09:00.100] - Autumn Graham

Yeah, I think greater than 12% is really questionable. It depends on the profitability of company. But generally 12% cost of debt is getting to unaffordable, particularly a long time period. But there's other avenues besides the bond market. You want to see if the company may have access to the banking market. Maybe they have a relationship with local markets or perhaps they have a very strong asset base off of which they can raise debt or equity financing. So you want to cheque all of those things if you're not feeling comfortable after going through that exercise. These are some of the companies that we think are vulnerable. But I don't want to leave it on a negative note here. I mean, I think that the positive news is that there is value in the asset class, particularly in high yield EM corporates. If you just look on an index basis, if you look at the high yield semi-broad, it yields over 11%. This is meaningfully higher than it's been over the past ten years. And if you stay away from these trouble spots and invest in the companies that you think will make it through the cycle, there's a lot of value.

[00:10:16.950] - Autumn Graham

So, who are these companies? These are large, well-established companies. Oftentimes you're going to be in double B rating category or higher.

[00:10:28.410] - John Mensack

Any sectors or regions that you find interesting?

[00:10:35.370] - Autumn Graham

So there's a number of companies in Brazil that, from a cyclical perspective, are going through some hard times right now, just in terms of perhaps the prices of their products being on the low end of the cycle. But these are large, diversified companies, operations in multiple different countries. They're double B rated and above. They have multiple bonds across their curve. We've followed these companies over the past seven to ten years and seen them be tested through time. Brazil has had a number of stress points over the past ten years. These companies have made it. And so these are some of the interesting cases that we find. I mean, additionally, companies that could have a supportive shareholder remain interesting. That could be a government or a state, or it could be on the private side, or even companies that have very strong asset bases that we think the company can really raise financing on the back of this, even if things got tough in the bond market, we think that they could pull through. And this is not a large part of the index, but clearly amortising project finance bonds that don't need to be refinanced at all.

[00:11:50.470] - Autumn Graham

These structures can do just fine in today's market environment.

[00:11:54.790] - John Mensack

Terrific. So how would you rate then the quality of the corporate accounting and the financials that your team really analyses very deeply relative to, say, developed companies.

[00:12:07.610] - Autumn Graham

So, I guess big caveat being that I've, as I said, spent my whole career within emerging markets, but I have seen it progress over time and over the past 15 years or so, I've seen a lot of progress here, again. So, there's a lot of variation in the credit quality and the size of these 750 plus issuers. We have the AA rated issuers in Asia and Middle east, all the way down to CCC rated issuers in Argentina and all over the world. Clearly these companies are different sizes and they'll have different disclosures, but I would say as a whole they've gotten better over time. The companies that make it to the bond market at all tend to be the largest, most well established companies within these countries. And at this point they have solid investor relations teams, they have sophisticated experience management teams, they have sustainability teams and they're improving their sustainability disclosures. So I would say except for the smallest companies, I think that the standards and the expectations are fairly high.

[00:13:28.850] - John Mensack

We're going to end here with, we're not ending in the next second or so, but we're going to kind of pivot here in our discussion and we're going to talk about the EMD corporate sub asset class through the lens of what we call the 3D reset, which is our view that we've entered a new era post global financial crisis. And our view is that inflation is likely to settle in at a level somewhat above post global financial crisis numbers. You might recall, I know you recall we had a hard time for a while, the Fed pushing inflation up to 2% or so, a CPI number up to 2%. We may be in for sort of a 3% inflation number going forward, that does have implications across the board. And that there are three drivers that we believe will be fundamental going forward. One is deglobalization, the other is decarbonization and then demographics. So we're going to pull each of these apart and then I'm going to ask you to maybe just give us some thoughts of the types of EM corporate bonds that would work in this type of environment. So let's start with deglobalization.

[00:14:37.170] - John Mensack

So certainly COVID, the war in Ukraine, all of the ongoing geopolitical tensions have led corporations to realise the vulnerability of their supply chains. And I guess I would stress that we're looking forward to see what's called a China plus one type of supply chain where China is not abandoned per se, but marginal supply chain. Now that there's a higher priority on the security of the supply chain, marginal supply chain capability will be built out. That just on the face of it is probably inflationary, as you know. And just stepping back and saying that EM markets, even if you exclude China, still represent eight of the top 15 destinations for foreign direct investment. So the trend towards nearshoring is prominent. I think in places like Poland, Hungary, Indonesia, Mexico. But what are some of the opportunities in the EM corporate world that you see that might work in a world that is moving towards deglobalization?

[00:15:44.590] - Autumn Graham

Yeah, sure. And I like the way that you kind of framed that. I think that deglobalization might have an aspect of kind of everyone's a loser, but you're really just seeing shifts in trade flows and investment patterns here. And then in that deglobalization paradigm we are looking for the potential winners of this nearshoring trend and you just named a number of them. Now when it comes to EM corporates, there's a very interesting sector within the Mexican real estate trust companies called fibras. So, in general, as you mentioned, Mexico can be a real winner here in the near shoring trend overall, it's obviously close to the US massive demand centre. It has low-cost labour force, it has free trade agreements in place, and politically it's at least neutral to both suppliers and consumers. So, it's a real potential winner in this new era. So when we're thinking about nearshoring with regards to Mexico, we're seeing a boom in the northern industrial manufacturing hubs in Mexico. Companies are being sold out before they're even constructed. And this is providing really good benefits for these fibras in terms of strong rental income as well as highly valued real estate portfolios.

[00:17:18.410] - Autumn Graham

And in addition, just positive sentiment towards the sector means that these companies are able to raise debt and equity funding at very attractive rates, which they can then use to either delever or to grow further and diversify, both of which are positive for the credits. So, this is really a very focused play on this nearshoring trend and a very clear way to kind of capture those trends.

[00:17:46.050] - John Mensack

Okay terrific, thank you for that. And what we always say too is that it's one thing to say you're going to electrify northern Mexico, it's another thing to actually accomplish it. Right? So, there's the opportunity we'll see. It's going to take good governance, it's going to take public private partnerships and limiting the graft whenever in a developed or an emerging economy, whenever a lot of money is thrown around. Let's shift gears then to decarbonization. And of course, the direction of travel for major governments and corporations, whether it be developed or emerging markets, is pretty clear. And the goal of achieving a less carbon intensive world will necessarily require significant amounts of raw materials that are plentiful within EM. So what are some of the opportunities that you see on a corporate side that can play into this decarbonization trend.

[00:18:40.870] - Autumn Graham

Yeah, there's a number of different opportunities all around the world, just focusing in on two. So I think that two countries that are making great strides are Chile and India. So, starting with Chile, the country has committed to getting renewables up to 80% of the energy mix by 2030. They want to remove coal entirely by at least 2040, and they're actually well ahead of schedule on removing coal. They're currently scheduled to get rid of 65% of it just by 2025. So, things are moving along at a fast clip in Chile. And I think that one of the best ways to support these large-scale transitions is through supporting the funding of the infrastructure needed for these transformations. That's often where the bottleneck is. So there's bonds that back the transmission line that connects a lot of the renewable generation capacity that's been built in the northern part of Chile. Chile is a long, skinny country, and it connects the generation up at the top, down to the demand centres that are in the southern part of the country, where that generation capacity is actually needed and is being consumed. So I think that that's a really nice way to support Chile's transition plans.

[00:20:01.970] - Autumn Graham

So moving to India, it probably doesn't make the headlines, I think, as much in the west, but it is something of a leader in the renewable space. It's fourth after China, US and Germany in terms of renewable generation and capacity. And there's a wealth of opportunities within the EM corporate space to support some of this renewable generation capacity, whether it's through hydro or solar or wind plants, or alternatively through holding company investment in the companies that are building out these assets, as well as some of the related infrastructure for India's transition plans. So, I think when you think, in particular for India, fast growing country with over 1.4 billion people, the impact that these investments are going to have is really quite meaningful. And I think that's a positive aspect of this sector.

[00:21:00.910] - John Mensack

Yeah, excellent. Okay, unless we're going to touch on the third D of the 3D Reset is demographics. And it's our view that declining populations, especially in developed markets, but also in some prominent EM markets as well, will just continue to drive, force technological innovation to further increase productivity. Now, clearly a lot of this innovation is going to come from the developed world, there's no doubt about it. But a lot of the componentry of that, the innovation systems, the chips and so forth, are going to come from emerging companies. So just any thoughts along those lines, Autumn?

[00:21:41.470] - Autumn Graham

Yeah, I think that's right. I think when you think about Smart appliances or AI, you don't naturally think of emerging markets. But you do see some of these companies like TSMC in Taiwan or SK Hynix in Korea, who are absolutely dominant in the semiconductor space. And these credits, they're less yieldy. They're very high quality, very advanced developed companies in developed countries. But the spreads on those credits should really remain supported given these long-term demand trends that you just laid out. So, I think that's an interesting and important aspect of that discussion.

[00:22:23.530] - John Mensack

Okay, terrific. Well, Autumn, this was great. Really appreciate your time today. It was good to see you, as always. And I just want to say, ladies and gentlemen, thanks so much for listening to this version of the Schroder's investor download on emerging market corporates. Have a great day.

[00:22:40.320] - Autumn Graham

Happy Halloween, John.

[00:22:42.080] - John Mensack

Happy Halloween, Autumn.

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Authors

John Mensack
Investment Director, Fixed Income
Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

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