Emerging Market Corporate Debt: A Potential Core Investment for Institutional Investors

The fastest growing segment of fixed income

Emerging market debt has gained significant prominence over the last two decades, in both economic and financial spheres. The share of emerging market bonds within the global bond market was around 10% in 2004, whereas now it accounts for almost one third of the global bond market.¹ We submit that it is an asset class that cannot be ignored anymore.

Within emerging market debt, emerging market hard currency corporate debt has gained even more traction. Far from a mature asset class but no longer the new kid on the block, it currently stands at 2.5 trillion USD¹, and deserves attention when compared to peers such as US corporates and on its own right. It is the fastest growing fixed income segment over the past 20 years, and spans more than 60 emerging market countries and 700 issuers.¹ It offers a multitude of potential benefits across the fixed income space including diversification for resilient income opportunities and the ability to express sectoral themes to complement sovereign macro views. Furthermore, different sovereigns often have varying structural and cyclical drivers, offering further diversification. Finally, we see abundant alpha opportunities from bottom-up credit stories. 

Figure 1:  Asset Class Growth

Source: JP Morgan, September 2024

Attractive risk return profile

We believe emerging market hard currency corporate debt is an asset class well suited for long term investors that seek structural risk premium and compelling risk adjusted returns.

If we divide emerging market (EM) corporate debt further into high yield (HY) and investment grade (IG) segments and compare it with developed market peers, we see that both EM HY and EM IG offer compelling yield pick-ups over their respective developed market (DM) peers, while the credit ratings are the same or similar between EM IG and DM IG and the credit ratings for EM HY are overall higher than DM HY.² If the combination of better credit ratings and higher yields sounds too good to be true, the yield pick-ups become even more compelling after adjusting for duration, as emerging market corporates typically have a shorter duration profile than their global and US peers. Regressions throughout time show that while the exact amount of yield pick-up changes, the fact that emerging market corporates offer stronger credit and duration risk adjusted rewards persists, evidencing structural risk premium that can be harvested by long term investors.³

Figure 2: Yield vs. Credit Rating

Dark Blue squares = Developed Markets.
Source: JP Morgan, Bloomberg, August 2024 It is not possible to invest directly in an index. Please see index descriptions at the end of this document. Past performance is not indicative of future results.

In addition to comparing credit quality adjusted yields between EM and DM, assessing volatility adjusted returns across different asset classes is another useful tool to help make asset allocation decisions. By examining index volatility and return data of EM and DM corporates over the past 10 years, we see that EM IG (0.67) has offered higher volatility adjusted returns than its US IG (0.51) and European IG (0.05) peers. EM HY (0.67) has offered similar volatility adjusted returns to US HY (0.70) and higher volatility adjusted returns than European HY (0.22), with a credit rating of EM HY (BB-) one notch higher than its DM peers (B+). Therefore, based on volatility adjusted return characteristics, EM hard currency corporates may be a strong contender for asset allocators.

Figure 3: Volatilitly-Adjusted Returns by Asset Class

Data as of September 2024
Source: JP Morgan, ICE Data, Bloomberg

The “Zip Code” effect

The next logical question is why such structural risk premium exists in EM corporate debt. We believe the “zip code” effect plays a large role here. It is much like the case of a house of high quality and specification but located in a not so desirable neighborhood, that may incur a discount to its fair value. In EM corporates, we see similarly rated companies often have better credit fundamentals and higher yields than DM peers. This is a result of the “sovereign rating cap” framework, which means that EM corporates, even the ones with the strongest fundamentals, cannot be rated above their respective sovereign rating unless these corporates are considered global, evidenced by deep revenue diversification and a large share of hard currency earnings. 

The “zip code” effect can lead to various investment opportunities. From the top-down perspective, this means the asset class is often perceived as riskier than we believe it actually is, leading to favorable strategic asset allocation considerations. From the bottom-up perspective, the co-independence between sovereigns and corporates can offer attractive alpha opportunities. The opportunities are particularly abundant in countries where the sovereign fundamentals are improving with structural reforms and/or more orthodox macroeconomic policies.  As these countries achieve sovereign rating upgrades, many corporates domiciled in these countries will also experience credit rating upgrades, in some cases from high yield to investment grade. Turkey is a good current example, where the country is undergoing positive macro adjustments and being awarded with gradual credit rating upgrades. Bottom-up opportunities may also arise for corporates domiciled in a country where the macroeconomic backdrop is challenging and/or investor sentiment is fragile, but the corporates have strong mitigating factors in place. For example, as a result of the fallout of the Chinese real estate sector, many offshore investors shy away from Chinese corporate bonds, especially Chinese High Yield corporate bonds, altogether. Nevertheless, we believe there are attractive and sound investment ideas such as Chinese multinational conglomerates with diversified offshore assets and the Macao gaming sector, that are better positioned and less impacted by negative Chinese onshore considerations.

Solid standalone corporate fundamentals

Away from the sovereign zip code effect, the solid and improving fundamentals of emerging market corporates cannot be overlooked. The strong fundamentals are evidenced by lower net leverage ratios at every rating bucket vs. developed market peers, strong access to refinancing via local markets and banks and prudent liability management leading to smooth debt maturity profiles.⁴

Figure 4: Net Leverage Ratios for EM and DM Corporates

Source: JP Morgan, June 2024.  It is not possible to invest directly in an index. Please see index descriptions at the end of this page.

Higher quality investment universe composition

Going forward, we anticipate the overall credit quality of EM corporates will continue to improve. We believe the elevated defaults in the last cou  ple of years caused by the Chinese real estate and Russian-Ukraine conflict are largely behind us as these defaulted bonds exit the universe. New issuances have been heavily skewed towards higher rated bonds and higher quality segments, supporting the composition of the investment universe tracked by widely used indices such as JP Morgan CEMBI Broad Diversified index.

According to JP Morgan’s report released in October 2024, the credit rating trend for EM corporates is at its most positive since 2012. From the beginning of 2024 to the end of Q3 2024, this universe has had +$172bn in upgrades vs -$112bn in downgrades, leading to a positive net rating action volume of 2.4% of bonds outstanding.⁵ More importantly, this net positive rating movement is a result of broad rating upgrades instead of any specific rating bucket, corporate sector or sovereign-driven actions. Looking at the migration between Investment Grade and High Yield, we believe that potential rising stars will outweigh the potential fallen angels, even after taking into account the possible downward credit rating trajectory of Israel caused by the current Middle East conflict.

Capturing favorable sectoral trends

Coming back to solid corporate fundamentals, there are certain sectors we particularly like as a result of their positive growth outlook, relevance to prominent global themes and operating and financing models. One example is infrastructure. In emerging market countries we still see the need for large infrastructure spending, ranging from growing renewable generation and grid expansion to building the necessary infrastructure to support growth in commodity trades. We see unique opportunities to gain exposure to project finance type structures that offer strong creditor protection features while benefiting from stable cash flow generation and strong asset quality.

Focusing more specifically on green opportunities, debt issuance from the renewable electricity sector in emerging markets presents an opportunity for investors to gain exposure to both the secular growth in developing countries’ energy demand and increasing governmental efforts to decarbonize the global economy. In order to encourage capacity additions, green electricity generation companies often benefit from favorable tariff arrangements such as price floors, guaranteed hard-currency payments and availability-based compensation. The predictable revenue picture such arrangements provide often translates to solid credit fundamentals, particularly on completed projects which will exhibit high operational margins and low maintenance capital expenditure requirements. A wide range of emerging market renewable companies and projects have been financed/refinanced in the Eurobond market, including solar plants in the UAE, hydroelectric generators in Turkey and wind projects in India. Having exposure to such assets provides EM corporate debt investors with good return prospects and useful diversification to traditional hydrocarbon credits.

Technological leapfrogging and innovation is another important sectoral trend to capture. The emerging market asset class includes countries at many different stages of economic development, and this translates to an interesting range of opportunities for corporate credit investors. In Africa, companies investing in the mobile telecommunication sector are driving technological leapfrogging, whereby countries are able to bypass the need for traditional fixed line infrastructure and instead expand internet penetration through cellular technologies. This presents investors with secular revenue growth opportunities, as mobile penetration levels continue to increase as towers are constructed across the continent, and also provides exposure to a sector that has a real impact on economic development, with positive externalities accruing to improved connectivity. As an investor, providing financing in this sector gives us the valuable opportunity to support the United Nations Sustainable Development objectives and to reduce poverty and inequality, with the believe that “to leave no one behind” is to leave no one off-grid. In Asia, where the situation is rather different from Africa but the sectoral trend is equally important, many higher-income emerging market countries in this region have been issuing hard currency corporate bonds to provide exposure to the latest technological developments across e-commerce, artificial intelligence and semi-conductor production. In addition to the exceptional growth opportunities associated with such innovation, credit fundamentals are often underpinned by significant cash generation and strong balance sheets.

Favorable technical tailwind

One interesting trend we have seen for the past couple of years is strong interest in emerging market hard currency corporates from global and crossover investors. For example, the widely used ICE BofA Global High Yield index now has 18% of its index weight to EM, compared to only 8% in 2004.⁶ In addition to the index weight increase, the EM segment of this global index has also outperformed significantly its US and European segments by more than 400 basis points year to date.⁶ Therefore, there is a strong argument that EM is a segment that global investors can no longer afford to ignore or underweight. Consequently, we are seeing heavier demand for the EM asset class. Combined with more recent limited supply from issuers, i.e. more investors seeking fewer bonds, we see that the yield pick-ups of EM over DM corporates, while they remain positive and we feel are worth seeking, are at the tighter end of their historical range. We think strong demand for EM corporates from this wider investor base will persist as a result of overall compelling yield levels, improving quality of the asset class and the significant diversification benefits. For institutional insurance investors, the investment grade segment may be particularly attractive as a core allocation, whereas the high yield segment can offer more dynamic opportunities to capture both positive bottom-up credit stories and sovereign structural reform trends.

At MacKay Shields, our deep experience in delivering sharp, integrated emerging market sovereign and corporate research, combined with our strong expertise in global fixed income and credit, enables us to identify both standalone emerging market and crossover global opportunities and deliver tailor made solutions to institutional investors.