• Compared to this time last year, valuations are markedly different for EM debt than for other opportunistic fixed income sectors.1
• Significant yield premiums compared to alternatives suggest greater investor opportunities for and resiliency within EM debt.
• Risks remain, but existing positions provide, in our view, adequate compensation and could offer compelling re-entry points for investors.
2013 was a painful year for EM debt investors. In retrospect, valuations got progressively tighter, bottoming at all-time lows in the spring.2 The “Taper Tantrum” of May and renewed fears of a Chinese hard landing resulted in a “reactive de-risking” among portfolio managers around the world. As a result, emerging market assets sold off in dramatic, successive waves. In response, EM officials scrambled to tighten policy and employ foreign exchange reserves to stem currency weakness.
One year later, the backdrop for valuations and vulnerabilities suggests greater potential resiliency for EM debt in our view. In this the first of a two-part series, we look at relative valuations among a variety of growth-sensitive fixed income sectors. As a result of our analysis, we believe that the current amount of cushion in EM debt compared to other alternatives warrants the consideration of asset allocators to continue increasing their holdings of emerging market fixed income.
EM yields have retraced since hitting fresh highs at the end of January but remain at elevated levels compared to last year.3 With the decrease in Treasury yields in the U.S., high-yield and investment-grade corporate bonds4 have actually rallied in price since last fall, with rates for speculative corporates dropping 160 basis points (bps) since last September to 5.09%.5 Last April, high-yield corporates offered comparable yields to EM local sovereign debt and more yield than EM corporate debt denominated in U.S. dollars.
Fast-forward to this April: EM local debt and EM corporate debt offer 160 bps and 64 bps more in yield than U.S. high-yield corporates. Yield pickup over U.S. investment-grade corporate bonds is almost 380 bps for EM local debt and 270 bps for EM corporate bonds, respectively. As shown in the table below, we believe that EM debt is now attractively priced compared to other U.S. fixed income sectors.
EM Corporate & Local Debt Yield vs. U.S. Alternatives
For definitions of terms and indexes in the chart, please visit our Glossary.
U.S. high-yield corporate and EM local debt might not be natural substitutes and involve different risk factors, such as local investor preferences and the assumption of non-U.S. currency risk in local debt. But in a yield-starved environment, picking up nearly 160 bps with an investment-grade portfolio remains compelling in our view.6 Over the longer term, we believe that these valuations will encourage many investors to take an opportunistic look at the costs, benefits and merits of these exposures.
A Comparison of Corporate Debt
Emerging market corporate debt may be seen as a more straightforward comparison for some. Both U.S. high-yield and EM corporate bonds are denominated in U.S. dollars. As such, both markets trade at a spread relative to U.S. Treasuries in order to compensate investors for taking on credit risk. EM corporate bonds are slightly longer in duration than high-yield bonds in aggregate, but are overwhelmingly (70%) composed of investment-grade issuers versus a, by definition, 100% speculative-grade portfolio.7 Given that these companies are headquartered in emerging markets, investors are compensated by an additional 64 bps in yield over high-yield corporate bonds, even though they represent higher-credit-quality businesses. Additionally, EM corporates feature only about 5% of overlap with the U.S. investment-grade and high-yield corporate universe.8
Given the potential for geopolitical risk, a discussion of emerging market corporate debt would not be complete without acknowledging the impact the current crisis has had on Russian corporate borrowing costs. Russian allocations within EM corporates may understandably give pause to some investors. However, after a de-escalation in tensions in recent days, markets appear to be trading more favorably. Coupled with the fact that nearly all of these businesses pose strategic long-term importance to the global economy, we continue to view the current difficulties as a long-term buying opportunity for active managers.