Aberdeen Standard Investments - Head of Corporate Debt, Paul Lukaszewski
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The coronavirus pandemic has confined many of us to our homes. Most economic activity has been suspended and the eventual downturn could be the most serious since the Great Depression of the 1930s.

Policymakers in the developed world have responded aggressively. Central banks flooded financial markets with liquidity, prudential regulators eased capital requirements for financial institutions, while fiscal authorities launched sizeable loan guarantee schemes.

US Federal Reserve (Fed) and European Central Bank (ECB) interventions boosted government bond prices and pushed sovereign yields down to negligible levels. For the uninitiated, as bond prices rise, yields fall, and vice versa.

At the same time, developed market credit spreads – the extra yield corporate bonds offer versus comparable government bonds – narrowed aggressively following the Fed and ECB’s bond purchases.

This has created  a headache for bond investors. Where do they look for investments that can generate a decent income stream amid falling bond yields and an uncertain outlook?

The answer may be found within the emerging markets (EM). More specifically, US dollar-denominated credit, or corporate debt, from the emerging markets, especially bonds issued by Asian borrowers.

In light of these extraordinary circumstances, here are three observations about the EM US dollar credit market worth knowing:

EM credit offers better value

Dollar-denominated EM credit looks more attractive than their developed market (DM) counterparts. That’s because investors are better compensated, without taking on significantly more risk.

For example, EM US dollar credit yields have been trading at a growing premium to US credit yields since the Fed announced its unlimited bond purchase programme in late March. This premium was 197 basis points, or 1.97%, as of May 29[1].

At the same time, EM corporate bond default rates are expected to be roughly the same as those in DMs. The US default rate is expected to be 9% during the next 12 months, according to an April 2020 Merrill Lynch forecast[2]. EM default rates are expected to be 9.4%.

Credit rating downgrades and bond default risk will be higher than normal during these troubled times. However, EM bond yield spreads – the extra yield EM credit pays relative to DM credit –  provide a bigger buffer against further shocks.

Active management isn’t optional

The term ‘emerging markets’ can hide big differences in the way individual countries and economies are managed, as well as the resilience of specific bond issuers.

Active management, as opposed to investing in a fund that tracks an index, seeks a deeper understanding of investments and the forces that affect them. It’s this attention to detail that will become even more important as fortunes diverge depending on specific circumstances.   

Those countries with weaker financial foundations, such as Argentina, can be expected to suffer more corporate defaults because of weak local currencies and sovereign risk overhang (when a country’s credit rating is lower than its highest-rated companies).

Large oil-exporting countries, for example Russia, may suffer more than other EMs as the suspension of international travel and economic activity combine to batter oil prices. Recent price falls for crude hit the bonds of weaker B-rated credits in Latin America and Africa particularly hard.

On the other hand, bigger EM economies that have substantial domestic markets will be better insulated from the contraction in international trade.

Policymakers in more developed Asian economies have been encouraging greater domestic consumption and developing the service sector. Household spending now accounts for 49.1% of economic activity in the East Asia and Pacific region[3].

Meanwhile, active management supports responsible, or sustainable, investing. This involves analysing the environmental, social and governance (ESG) issues that can affect the financial performance of an investment.   

Responsible investing is now important to many EM credit investors. This can be seen in a rising number of ESG-themed investment mandates from institutional investors, such as the Asian Infrastructure Investment Bank.

It’s hard to definitively link a company’s adoption of ESG principles with better corporate performance. However, companies that care about their impact on the environment and the wider community, are also likely to take their responsibilities to investors more seriously.

Asian credit – a class apart

Dollar-denominated Asian credit offers the best risk-adjusted returns relative to comparable US and EM corporate bonds in general. As of end May, Asian credit yielded some 3.7%, compared to about 3.2% and around 5.3% respectively.[4] It pays a higher yield than US credit, without significant additional risk, but is less risky than investing in the corporate bonds of the broader emerging markets.  

Credit ratings agency Moody’s expects this asset class to experience lower default rates than both risky high-yield US credit, and global emerging market corporate bonds[5].

Why is Asian credit less risky? This is partly due to the growth of a substantial domestic investor base which has reduced the risk of capital flight during times of stress.

In fact, historical volatility has been similar to equivalent US credit, and lower than comparable bonds from the wider EM asset class[6]. Over the past decade, Asian credit has delivered the best Sharpe ratio – a measure of investment return adjusted for risk – of all credit markets[7]

From a wider perspective, issuers from Greater China, Indonesia, Korea, India, Malaysia, Thailand and the Philippines make up some 98% of the Asian credit market[8]. These countries all boast investment-grade bond ratings. Better economic foundations, and less volatile local currencies, mean issuers operate in more stable environments.

The credit quality of this asset class has improved, which implies a lower risk of default. Riskier high-yield bonds account for only 22% of the Asian credit market, less than the 33% for the broader emerging markets. A decade ago, this situation would have been reversed, with the Asian market featuring a higher percentage of high-yield issuers than the broader EM asset class[9].

Finally, lower oil prices have been less disruptive for Asian credit. Most of the region’s oil and gas borrowers, including  China’s CNOOC, Thailand’s PTT and India’s ONGC, are deemed less risky because they are  government backed. Most Asian countries, except Malaysia, even benefit from low prices since they are net oil importers.

[1] JPM Indices, May 2020

[2] BofA Global Research, April 2020

[3] World Bank, World Development Indicators, May 2020

[4] JPM Indices, May 2020

[5] Moody’s: expect default rate to rise for APAC high-yield non-financial corporates as coronavirus disruptions raise default risk, 29 April 2020

[6] BofA Global Research, ICE indices, April 2020

[7] BofA Global Research, ICE indices, April 2020

[8] JPM Indices, April 2020

[9] JPM Indices, April 2020

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