When investors think of emerging market (EM) growth, they are often drawn to emerging market equities as their first and only stop. But with the path of interest rates now potentially “lower for longer” under a Yellen Federal Reserve, bond market investors appear to be resuming their global hunt for yield. In our view, emerging market corporate bonds may represent an attractive option for investors who believe in the emerging market story but want to participate in a lower-volatility, higher-income approach than emerging market equities.
Emerging Market Corporations
When talking about EM corporate bonds, we are referring to bonds that are issued in U.S. dollars and trade at credit spreads relative to U.S. Treasury debt (just like bonds issued by U.S. companies). This market has grown in size as higher-credit-quality EM governments with more established credit histories have increasingly migrated their debt issuance to locally denominated debt due to lower funding costs and risks.1 However, the market does not allow all borrowers to issue local currency debt.
In our view, this has the effect of biasing the investable universe of emerging market government debt denominated in U.S. dollars to less desirable credit risks. Ultimately, we believe that the risk/reward trade-off of lending to a large, multinational corporation headquartered in an emerging market country may provide a better balance between yield, credit quality and interest rate risk than dollar-denominated debt issued by EM governments.
Given the robust demand from international investors for credit risk in emerging markets denominated in U.S. dollars, we believe the EM corporate asset class may continue to grow at the expense of EM government debt. In our view, this may be due to the increasing degree of familiarity investors have with these corporations. After investing in these companies’ equity for the last decade, investors have seen many of them grow to multi-billion-dollar concerns. However, in both instances (equity and debt), investors are exposed to potential transfer risk. But just as in the United States, bondholders have a direct claim on assets during a credit event, whereas equity holders are lower in the capital structure and are paid last, if at all.
Why Not Government Debt?
In our view, we believe that the current compensation offered by the market for bearing transfer risk is attractively priced in the bond market. Additionally, if recent history has taught us anything, investing in government debt with a significant amount of credit risk (such as Greece) seems counterintuitive. If a government is unable to repay their debt, what recourse do creditors necessarily have? Also, generally speaking, governments derive their revenues from taxation, whereas corporations derive them through the sale of goods or services. In our opinion, the more intuitive way of profiting from emerging market growth is to be found through investments in the companies that are the actual drivers of these higher growth rates in emerging markets. In order for many of these companies to grow, they need access to capital. Emerging market corporate debt is one means of financing their growing businesses.