By now, the benefits and risks of investing in emerging market debt (EMD) have become well-known, and to many asset allocators, it remains a tempting proposition. The asset class offers access to new markets, providing opportunities to benefit from the creation of new consumer classes. There is also the ability diversify within a sector. Certain domestic industries - for example, steel - could at some point struggle to compete against lower-cost production from a developing economy. By investing in that economy, the investor can still maintain exposure to the sector.
Most alluring to asset allocators, however, has been the premium in yield that EMD has almost always offered when compared to its developed market peers. From the beginning of 2010 until the end of 2015, an investor could have earned, on average, nearly 100 extra basis points by shifting from US high yield corporate (US) into emerging market high yield corporate debt (EM). That differential has varied over time, and occasionally the gap would temporarily narrow, or even close. Most of the time, however, asset allocators were rewarded for investing abroad with consistent returns above their domestic indices.
Whether this persistent premium ever made any sense was always up for debate. The ostensible reasons for the pick- up in yield - domestic bond markets typically offer better liquidity and more robust creditor jurisdictions, to name two examples - were correct, but redundant. Ratings agencies are supposed to do the job of incorporating these elements into their ratings: one index of high yield securities should not, on average, yield more than another similarly-rated index for an extended period. Indeed, judged purely by conventional financial metrics, EM corporations are more conservatively financed; the lower ratings were meant to reflect the 'emerging market' risk. Nevertheless, the premium between US high yield and EM high yield persisted for most of the past five years.
The Impact of Commodities
Any number of factors could have contributed to the compression in yields between the two indices. But it is almost certain that an important contributor was the collapse of oil and commodity prices that began in earnest in mid-2014, and continued until early 2016. The slide of energy and commodities prices had the predictable effect of devastating the bond prices of highly-leveraged companies engaged in exploration or mining. From mid- 2014 to early 2016, the yield on the energy subcomponent of the US index rose from approximately 5% to nearly 20%. The lowest-rated part of the energy index, the CCC segment, did even worse, spiking from 7% to 45% during that same time period.
In addition to credits that were included in the index at the beginning of the period, there were a number of "fallen angels" - companies that lost their investment grade rating. Several of these companies had large capital structures, and they exerted a noticeable influence on overall index yields. Interestingly, these commodity "fallen angels" bucked a historical trend: in the past, fallen angels entered the index with comparatively low yields (because of their investment grade status), and so caused the overall index yield to fall. This time, however, bonds entering the index were trading at very high yields even compared to the credit rating they would ultimately achieve, causing the index to widen.
EM corporate debt had the opposite experience. A high portion of energy companies in the EM index were not completely private, but were quasi-sovereigns (companies which are either partially owned by a government or have an implicit or explicit guarantee by the government). Most quasi-sovereign bonds benefit from the expectation that, should they enter financial distress, they will receive government support. This meant that a larger proportion of energy companies in the EM corporate index traded at lower yields than their ratings would imply. In this way, the impact of credit rating movements following the slide in commodity prices pushed yields of the US and EM high yield indices in opposite directions.
Differences in regional demand can also play a role. Although bonds of companies outside of developed markets are often lumped together under the label of "emerging market debt", differences in local demand can vary widely. When the double-B component of the EM index is broken down and examined by geographical region (viz., Latin America, Asia and Europe) the Latin and European components still offer more yield than the US double-B subcomponent; the Asian subcomponent, however, yields significantly less than the US double-B subcomponent. This is partly the result of demand from local Asian private banks, which are required to purchase bonds in their home region. Since they are unable to purchase bonds in the other regions, there are imbalances of demand which can drive one subcomponent tighter. Even as the EM index valuations may look high relative to the US index, not all regions may uniformly look expensive.
Lack of New Issuance Has Been Supportive
Another positive driver for EM high yield has been new issuance – or rather, the lack of it. From 2010 through 2016, the EM index enjoyed a period of remarkable growth, both in the total principal amount of bonds outstanding, as well as the number of issuers that came to market. Although an increase in size and diversity of issuers is generally helpful for liquidity, excessive activity in the primary market can put upward pressure on yields, creating supply that needs to be absorbed, and requiring investors to diligence new credits.
The rise of geopolitical risk factors, including Russia's actions towards Ukraine and the rapid fall in commodity prices, brought the pace of primary market activity down significantly. New dollar-denominated high yield issuance fell nearly 60% from 2014 to 2015.
Even more dramatic has been the fall in the number of debut issuers, which declined from 108 to 34 during the same period. The implication, though, is that a large portion of new issuance has been conducted by companies with existing bonds outstanding, and are therefore already known to the market. These companies are increasingly accessing the bond market intending to conduct liability management exercises, to extend the average maturity of their capital structure, and to relieve the pressure of short- term financing needs.
The result has been to tilt the composition of the index towards companies that are established issuers which are taking advantage of favourable market conditions to improve their balance sheets. This has added to the appeal of EM debt to investors.
Falling Default Rates
Rising defaults likely played an additional role in how investors viewed the difference in credit risk between the two indices. Since the beginning of 2011 through September 2015, the US twelve-month rolling default rate averaged 1.95%, below the 2.28% average for EM high yield during that same period. Over the past year, however, that trend has changed. The default rate in the US has now reached 6.67%, while the EM high yield default rate stands at 4.71%. Recovery rates, meanwhile, have remained similar for both types of bonds. With a rising default rate, and similar recoveries, investors could naturally be expected to migrate towards EM debt.
Without the traditional premium that EM corporate high yield debt offered, asset allocators will likely take pause when they are considering investing in the asset class. But those allocators would do well to keep in mind some of the factors that have caused the aggregate yields to converge. Examining the behaviour of the subcomponents of these indices can provide important clues to where investors can find value and future returns.