"We believe investment opportunities and risks cannot be fully evaluated using traditional financial metrics alone. Combining these with ESG criteria is a source of long-term value and risk mitigation."
Exceptionally high yields on emerging market bonds
At the moment Emerging market corporates are offering exceptionally high all-in yields, comparable to the periods during the 2008/2009 financial crisis and after the dotcom bubble and the events of September 11, 2001. The post-Covid environment and Russian-Ukraine invasion have created conditions for higher inflation and therefore rising yields have made the asset class attractive. A large part is of course down to the levels of the U.S. Treasury market but for an average rating of BBB- and a duration of just above four years we find the valuation levels compelling, especially when we factor in our expectations for limited default rates in the near-term. Just to emphasize this, the current yield to maturity is 8.1% [1] so there would need to be significant spread widening or considerably higher U.S. interest rates to erode the carry of the asset class. This is a rare opportunity not seen in the past decade to lock in yields.
Yield to maturity – EM Corporate bonds
Defensive sectors should outperform
We do not target a sector allocation per se as our approach for emerging market corporate bonds is largely "bottom-up" or issuer selection driven but we do focus on the overall business and emerging market credit cycles. From this perspective it is important to establish what stage of the relevant cycles we find ourselves in and therefore calibrate our risk exposure to certain sectors. We are more cautious on cyclical sectors in favour of defensive sectors. Regardless of whether there will be a mild global slowdown or in case something more pronounced develops following the tightening cycles of most major central banks, we expect defensive sectors to outperform.
Cautious on China but positive on Latin America
China remains one of the most important markets in EM Credit. As the world's largest commodity importer, it has a major influence on most emerging market countries that are active in extractive industries, whilst geopolitically China is also a significant player. Our strategy only has selective exposure to China as we viewed the euphoria that took hold at the beginning of the year regarding the country’s exit from zero covid as misplaced. We also maintain an underweight in the ailing real estate sector and believe a meaningful large-scale policy intervention or stimulus measures will be required to turn around the confidence crisis.
We have considerable exposure to Latin America, preferably where we believe that the political risk premia have made companies with strong credit profiles attractive. We for example see value in selective issuers in Colombia, Peru and Chile. Having been cautious on Brazil at the beginning of the year due to high onshore rates and a number of high-profile credit events, we have been adding specific issuers, although we do view the overall complex as relatively rich at the moment. We also note that the El Nino weather pattern is likely to benefit some of our positions due to increased rain fall in South America, whilst we expect some sectors and countries in Asia to be impacted by drought conditions.
Integrating sustainability to tackle climate change
We believe investment opportunities and risks cannot be fully evaluated using traditional financial metrics alone. Combining these with ESG criteria is a source of long-term value and risk mitigation. Climate change is a major and substantial challenge in sustainable development, particularly in emerging market countries. Accordingly, it is assessed in all our ESG sector models and is a major source of risk for high-impact sectors such as energy, transport and materials, which form a significant part of the emerging market corporate bond universe. On top of this, our emerging market corporate debt strategy targets a carbon footprint below the widely used asset class index (J.P. Morgan CEMBI Broad Diversified). The most recent carbon footprint of the portfolio was 79% below the level of the index[2]. For issuers where we see potential controversies we aim to use engagement in the aim to improve their practices.
Supporting factors
2022 was a year characterized by outflows from emerging market debt funds, whilst rising yields have created more volatile and challenging market conditions in 2022 and 2023. We believe that the potential end of a Fed hiking cycle will create an environment conducive to a return of inflows into EM credit. Although the higher yield environment has created competition from developed market funds as their offering is now more attractive, we believe the much lower issuance in emerging markets has created benign demand and supply dynamics that have supported spreads over the last twelve months as reflows from coupons and amortizations outweighed new issuance. Forecasts by JPMorgan indicate that EM corporate primary supply will be around $273 billion, around half the record of $542 billion issued in 2021, whilst solid reflows during 2023 mean the net new financing will likely be negative at around $60 billion and we expect this trend to continue into 2024.
Some volatility, which can be mitigated through issuer selection
Across fixed income, emerging market bonds are generally more volatile. However, given the average investment-grade rating of Baa3/BBB- and the short duration of the EM corporate bond market, volatility tends to be lower compared to US high-yield bonds (8.1 %), EM sovereign hard (10.2%) and local currency (10.9%2). If we take the S&P 500 or the emerging equity index as an example, the three-year volatility is closer to 18% for both, whilst EM corporates are around 6.6%[3].
Higher volatility in credit markets can also represent an opportunity for investors who focus more on realized credit losses as a measure of risk. Long periods of quantitative easing contained volatility and led to a more uniform pricing of risk. This has now shifted with the higher risk-free rate now driving a higher level of dispersion. We believe that our extensive due diligence process, that includes a thorough analysis of issuers' creditworthiness to avoid credit deteriorations, makes sense in this environment.
Overall we regard the high yields currently available in EM Corporate credit as a good reason for a strategic long-term allocation. Whilst spread markets are slightly within long-term averages we believe that any material spread widening from here will likely provide a compelling entry point.
The most significant risks associated with investing in the Emerging Market Corporate bond strategy are: Risk of loss of capital, Interest rate risk, Credit risk, High Yield risk, Liquidity risk, Risk associated with derivative financial instruments, Counterparty risk, Emerging countries risk, Sustainability risk.
This list is not exhaustive and more details on risks associated with investing in the strategy are available in the Prospectus and KID.
This is a marketing communication. This document is provided for information purposes only it and does not constitute an offer to buy or sell financial instruments, nor does it represent an investment recommendation or confirm any kind of transaction. The opinions, analyses and views expressed in this document represent Candriam's views only. Although Candriam selects carefully the data and sources within this document, errors or omissions cannot be excluded a priori. Candriam cannot be held liable for any direct or indirect losses as a result of the use of this document. The intellectual property rights of Candriam must be respected at all times, contents of this document may not be reproduced without prior written approval.
Warning: Past performance of a given financial instrument or index or an investment service or strategy, or simulations of past performance, or forecasts of future performance does not predict future returns. Gross performances may be impacted by commissions, fees and other expenses. Performances expressed in a currency other than that of the investor's country of residence are subject to exchange rate fluctuations, with a negative or positive impact on gains. If the present document refers to a specific tax treatment, such information depends on the individual situation of each investor and may change. The risk of loss of the principal is borne by the investor.
Information on sustainability-related aspects: the information on sustainability-related aspects contained in this communication are available on Candriam webpage https://www.candriam.com/en/professional/sfdr/.
[1] As of 5th October 2023
[2] For Candriam Bonds – Emerging Markets Corporate, data as of 6th October 2023
[3] Candriam, JPM, ICE, Bloomberg, as at October 5th, 2023. 3-year volatility on weekly data
