The COVID-19 pandemic has accentuated economic growth differences across many regions of the world. Although first affected by the crisis, Asia has become a notable outperformer and even succeeded in posting positive economic growth in the second quarter. On the other hand, developed market economies have been particularly hard hit, with GDP collapsing by as much as 23% over the same period. This decline is even far in excess of the worst performing emerging market (EM) region, Latin America, which saw its GDP fall by close to 13%.
EM governments have faced the same challenges as governments the world over after implementing large spending programmes in order to sustain demand. While some countries like Brazil and South Africa have run up large fiscal deficits, that picture is not uniform across EM. Some countries in emerging Asia have fiscal positions that certain developed economies could only dream of – highlighting again the diversity of economic realities across EM.
While the glut of global central bank liquidity has been instrumental in propping up asset prices, it has also driven yields lower. This has reignited a search for yield from investors. While the sheer size of US corporate credit and municipal bond markets mean they dominate the credit opportunity set available to global investors, they’re exposed to a singular regional economic risk in the shape of the US economy.
As an asset class, EM debt does not suffer from such concentrated economic risks. It benefits from the geographic and economic diversity on offer from the more than 60 economies spread across multiple continents.
And it is EM corporate debt, a hard currency EM asset class that’s often overlooked by investors, that currently provides some particularly compelling opportunities.
For yield-starved investors, EM corporate debt offers an attractive after-hedging yield at a lower average duration than US equivalents. For 5 years of duration, it offers close to 4.3% yield (when hedged back to the Australian dollar). For US aggregate credit this yield is just 1.8% for a duration of 8 years.
There is also a myth that EM corporates are a high yield (HY) asset class with weaker fundamentals than their US and European counterparts. This is not the case. 58% of the investment universe is investment grade, leading to an overall rating of BBB. EM corporates also employ lower levels of leverage, and if anything, they have entered this crisis on a stronger footing by reducing leverage over the last number of years. They have achieved this by selling assets to buy back debt, while also engaging in liability management exercises to extend their debt maturity profile during favourable market conditions.
This, together with strong support from EM authorities on the fiscal and monetary side, should lead to a relatively contained default rate this year. So far this year, defaults have been 2.5% of the EM HY universe, versus 3.8% for US HY. We expect it to rise to 4.5% by year end, but this is still far below the 10.8% recorded during the 2008 crisis.
Finally, it is important to recognise the role that ESG considerations play in EM corporate bond analysis. This is borne out by the evidence. Looking at EM corporate defaults over the past 5 years, we have found that the biggest contribution to defaults has been issuers with poor ESG scores. The worst 20% ESG scoring companies were responsible for 70% of the defaults over this period. ESG analysis is clearly not a tick-boxing exercise but an important tool to produce alpha and manage risk.
COVID-19 has laid bare the risks and challenges that many economies around the world face. EM economies, particularly in Asia, have been notably resilient. With the glut of global stimulus likely to keep yields supressed for a long period to come, Australian investors should consider the lesser explored corners of the investment grade hard currency credit universe, such as EM corporate credit, for gains in yield and diversification.
