ETF Trends
ETF Trends

In recent months, several media reports have warned of an impending implosion in emerging market (EM) finance. In many of these reports, journalists have warned that after years of easy money from the Federal Reserve (Fed), emerging market fixed income would soon come under considerable pressure. In response to these reports, we seek to highlight the three most common myths surrounding emerging market corporate credit. Below, we restate their claims and refute their conclusions about emerging market fixed income. In our view, valuations in emerging market corporate debt could represent an attractive entry point for patient investors who are focused on total returns.

Myth #1: Rapid Growth in EM Corporate Issuance Implies Higher Default Risk

A similar concern surrounds not only the serviceability of the debt, but also the massive increase in the EM corporate bond market over the past eight years. In fact, the amount of debt outstanding has increased tenfold over this period!1 For some journalists, this increase points to an increased likelihood of default. However, what many fail to realize can be distilled into a few key points:

1. Composition of emerging market financing has evolved

a. Historically, emerging market corporations have borrowed money from European banks in the form of loans.

i. As European banks have sought to reduce risk and de-lever, they have retreated from new loan issuance to EM corporations.2
ii. As more EM corporations developed a longer credit history, they sought to extend the maturity profile of their borrowing by issuing more bonds.
iii. While net leverage levels have increased for some issuers, most emerging market corporations remain much less leveraged across the ratings spectrum than their competitors in developed markets.3

b. Access to global credit markets is a testament to the development of EM economies and the emergence of many EM corporations as global industry leaders.

2. Leverage in emerging markets was, and still is, considerably lower than in developed markets.

a. Emerging markets currently account for over 40% of global economic output4 but only 12% of the bond market5.
b. Therefore, even though the market has increased by a significant multiple, it has been increasing from an extremely low base.
c. EM corporate debt has grown at about the same pace as the European high yield market over this period. However, EM corporate issuance has been dominated by investment-grade borrowers.6
d. By gaining access to longer and more diverse sources of capital through the global fixed income markets, EM corporates may now actually pose less risk to investors, given that they do not need to constantly tap or roll over credit lines to continue to grow their businesses.

Myth #2: EM Corporations Are in Trouble Due to U.S. Dollar Strength

Currency investing is hot right now. The premise for concern about “King Dollar” isn’t wrong, but its focus may be misplaced. Critics believe that since EM corporations have borrowed in U.S. dollars, they have an asset-liability mismatch. Since the U.S. dollar is stronger than most emerging market currencies, the cost of EM corporations’ debt in local currency terms prompts concern about their ability to repay. While a mismatch might exist for some domestically focused operated companies, the investable universe of emerging market corporate debt is quite broad, and it includes many industries that generate hard currency revenues.7

In our view, dollar strength is less of a concern because a majority of these large, EM issuers, such as commodity producers, have dollar-denominated revenues that will be used to service their debt. While these businesses inevitably sell a portion of their oil, copper, steel, or gold domestically, they are actually producing these goods for sale on the global markets. Today, most international commodity markets use the U.S. dollar as their principal settlement currency. As long as these companies can generate revenues in excess of their costs, they should be able to continue to service their U.S.-dollar-denominated debt. In fact, for companies with considerable local-currency costs and dollar-based revenues, margins could actually increase, since dollar revenues rise relative to local costs, which decline along with the local currency. For example, JB Y Compania, S.A. de C.V., the owner of Jose Cuervo Tequila, derives over 60% of its revenue from exports to developed markets outside of its operations in Mexico.8

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