Opportunities in the EM Corporate Bond Market


September 15, 2016

While EM corporate credit fundamentals are starting to improve, driven by a pickup in EM growth and commodity price stabilization, we still expect corporate default rates to increase in the coming quarters, as deterioration in recent years has left pockets of the market vulnerable to periods of risk aversion. That said, EM fundamentals remain healthier than those of DM corporate peers, and we believe investors are also compensated better for the risks. EM corporate bonds trade more than +100bps wide to DM corporate bonds on an outright basis, and offer a more attractive spread per turn of leverage at each rating level than their developed market peers as well. Moreover, we expect a period of deleveraging to begin in early 2017 for EM corporates, which should provide the backdrop for the asset class to outperform global fixed income peers in the coming years. As always, differentiating between credits will remain critical to capturing this outperformance. 

Since the taper tantrum in 2013, concerns of a brewing corporate debt crisis in Emerging Markets (EM) have waxed and waned, dependent largely on the actions of global central banks. Earlier this year, investors were concerned that a hawkish Fed would drive interest rates and the U.S. dollar higher and that this, coupled with weak global growth and depressed commodity prices, would put pressure on the increasingly leveraged balance sheets of EM corporate issuers. Fast forward to today and these investor concerns have been pushed to the backburner as global interest rates have declined, commodity prices have rebounded, and clear signs of a pickup in EM growth rates are emerging.

But, while EM corporate bonds have returned 10% year-to-date, putting 2016 on track to be one of the best years in the asset class’s history, this rally has, to a large extent, been driven more by accommodative global central bank policies than improving fundamentals. To that end, the impressive YTD returns in the EM corporate market are only in line with, and not better than, those of global fixed income peers. While the current “reach for yield” can certainly continue to drive strong absolute performance of EM corporates in the near term, we believe we need to see clearer signs of a bottoming out in the corporate credit cycle before a sustained period of outperformance by the asset class. On that note, there are signs that corporate credit fundamentals are improving – better economic growth momentum, stronger commodity markets and balance sheet deleveraging – and, while there are risks in different pockets of the market, we believe these risks are idiosyncratic rather than systemic.

Total Returns Across Asset Classes

Source: JP Morgan, Bloomberg. Data as of September 14, 2016

Concerns Over EM Corporate Indebtedness are Not Unjustified, But They’re Overblown…

While investor concerns over EM corporate indebtedness are understandable, we believe they are overblown. There are certainly risks in some sectors and economies, particularly those dependent on commodities, though in our view, the risks appear to be isolated, rather than broad based. Consider the following:

  • Dollar denominated corporate debt growth has not been excessive. The dollar denominated EM corporate bond market has multiplied in size by over 4x since the Global Financial Crisis (from $280bn to $1.2 trillion). First, this reflects organic growth in the asset class, with 15 new countries represented during that time. In addition, the size of the DM corporate bond market doubled in the same period (from $3.1trn to $6.4trn), and EM still represents just 15% of the global corporate bond market. While this is up from 8% in 2008, EM still appears to be underrepresented if we consider that emerging economies represent roughly 58% of global GDP .
  • Corporate indebtedness looks manageable relative to GDP in most major EM economies. Outside of China, corporate credit risks generally appear to be benign in EM. Non-financial corporate credit (NFC) to GDP has risen only gradually in EM ex-China since 2007, to levels of less than 50% in 2015 in the majority of major EM economies. Moreover, nearly every major EM economy has an NFC debt to GDP ratio below that of the median DM economy.
  • China is a clear pocket of risk within EM, as NFC debt to GDP has risen from already elevated levels of 100% in 2007, to nearly 175% in 2015. We do think the country’s corporate leverage problem poses a significant risk to both EM and DM financial markets, but view the likelihood of an unmanageable default crisis in the near term as low, given the country’s substantial financial resources and our expectations for a slowdown in growth, but no hard landing.

Leverage in EM ex-China Appears Benign Relative to Developed Markets

Source: BIS; Data as of 12/31/2015. Averages in the top chart are calculated on a nominal GDP weighted basis.

  • Rising corporate leverage is not an EM-specific phenomenon. There’s no question that EM corporate credit fundamentals have broadly deteriorated since the global financial crisis. Earnings have been depressed, driven initially by slowing growth rates and exacerbated more recently by the steep drop in commodity prices. Although debt growth has been anemic in the last year – a fact that is often overlooked – EM corporate leverage still rose to its highest level in at least a decade (2.25x) in 2015 on weak cashflow. However, it remains well below that of its U.S. peers on average, and has also deteriorated less rapidly in EM compared to the U.S. in the past year.

EM Leverage is Rising, But Remains Below U.S. Levels

Source: Bank of America Merrill Lynch

  • While EM default rates have been elevated since 2012, they have held up better than U.S. HY. U.S. HY default rates have risen to 4.9% in 2016, surpassing those in EM, which stand at 3.7% currently. EM default rates are expected to increase to 5.5% heading into the balance of the year, driven by a cohort of smaller commodity companies which are mainly trading at distressed levels. Even with this pickup, defaults in EM are expected to come in slightly below U.S. HY (6% forecast).

Default Rates Likely to Remain Lower in EM Than the U.S.

Source: JP Morgan

  • Within EM, significant credit deterioration appears to be isolated. Most of the damage in the past year has occurred in either commodity sectors (Energy and Materials) or the HY property sector (55% of issuers in our sample come from China). No other major segment of the EM corporate market saw leverage rise by more than half a turn in 2015.
  • Leverage has risen the most in sectors with low leverage to begin with, and fallen in highly leveraged sectors. A closer look at leverage actually shows the largest increases over the past year generally came in sectors that had very low leverage to begin with (i.e. Energy, Retail) while the more highly leveraged sectors (ie. Transportation, Food) saw the biggest declines in leverage during 2015.
  • EM corporate liquidity remains exceptionally strong. EM corporate issuers have become predisposed to manage liquidity conservatively, having been through numerous periods of restricted access to international markets. EM corporates have kept an average of 30% of their total debt loads in cash on their balance sheets since 2007, which is far more than the 15%-20% cash levels U.S. issuers tend to maintain. In addition, EM corporate management teams have been in repair mode over the last eighteen to twenty four months, cutting capital expenditures, prepaying high coupon debt (rather than issuing debt to buy back shares, as we have seen in the U.S. IG market for example), and selling non-core assets. This conservative behavior has allowed EM issuers to maintain liquidity and weather the storm, and has also set many issuers up to deleverage meaningfully, as EM growth picks up and commodity prices continue to recover from depressed levels.

Issuers Have Been Conservative, With a Focus on Cutting Capex

Source: Bank of America Merrill Lynch

Far Better Fundamentals + Wider Spreads = More Value in EM Corporates Than U.S. Corporates

We believe that 2016 is likely to mark the peak of the EM corporate credit cycle, and we expect a period of deleveraging followed by declining default rates to begin in early 2017. We see clear signs that issuers are on the path to deleveraging, as earnings are improving and debt growth has slowed, but of course exogenous factors could undermine this progress and leave stressed pockets of the market vulnerable to periods of risk aversion.

EM Earnings Expectations Recovering

Y/Y Change in 12M Forward EM Earnings Expectations

Source: TCW, Bloomberg

Ultimately, we think the relative case for buying EM corporates is clear, given superior fundamentals and still higher yields than similarly rated U.S. peers. Investors are paid more than twice as much spread per turn of leverage to own EM corporate bonds (160bps/x) than they are for holding U.S. corporates (75bps/x). Put differently, for every unit of a bond issuer’s credit risk, investors are paid 85bps more, on average, for an emerging market corporate versus a U.S. corporate.

To be fair, we agree that some degree of premium is justified by factors such as 1) lower expected recovery rates, 2) less developed bankruptcy regimes, and 3) lower transparency/ weaker corporate governance standards, but we expect the current spread per turn of leverage premium between EM and U.S. corporates to gradually decline over time, as improvements to EM corporate credit fundamentals outpace those in the U.S. over the next year, and this translates to a more benign default environment for EM HY issuers compared to their U.S. HY peers.

EM Compensates Investors Better Than U.S. in Each Rating Category

Source: TCW, Bloomberg, Bank of America Merrill Lynch

We already see a growing number of improving idiosyncratic corporate stories popping up across EM, and we expect this opportunity set to continue to grow and broaden out as credit cycles in more EM countries turn the corner in the coming year.

Finally, an important point to keep in mind in thinking about EM corporates, is that EM is not one homogenous asset class. Global EMs are not moving through their credit cycles in tandem, and while certain countries, like China, are further from their cyclical turning points, we’re seeing improving outlooks for economies like Russia and Brazil, where growth appears to have bottomed. We believe EM corporates have the potential to outperform global fixed income peers in the coming years, but acknowledging the risks and navigating through them will be critical to capturing this outperformance.

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW