Is EM corporate debt a good house in a bad postcode?

This has been a rancid year for emerging markets. EM stocks and bonds have both lost 20 per cent over fears that a mix of homegrown messes and massive macro shocks like the Fed’s rate hikes will cause carnage.

But some investors are convinced there is a golden opportunity lurking in one particular corner of the EM shitshow asset complex: corporate debt.

Thanks to a horde of western bond refugees desperate for yield they cannot find at home, the developing world’s corporate bond market has exploded over the past decade. This is now a $1.3tn asset class, with 810 different companies represented in JPMorgan’s main EM corporate bond index, up from 332 a decade ago.

The index has been dealt a pummeling this year and is down just over 12 per cent. That makes it all the more noteworthy that both Vanguard and Gramercy this week published research saying EM corporate debt now looks an attractive bet.

From Gramercy:

Despite the rising macroeconomic concerns around the world, EM corporates continued to show strong results in 1Q22. Revenues and EBITDA increased by 25% year-over-year, driven especially by strong numbers from commodity-exposed companies and partly by the nominal effects of higher inflation. Ebitda margins remain at historically high levels. Beyond that, disciplined capital allocation and sound cost management have led to strong cash generation, as evidenced by decreasing net debt among EM corporates since 1Q21. Across multiple sectors, pent-up demand amid continuing supply constraints have enabled companies to successfully implement price hikes to offset rising input, transport and labor costs.

Cynics might point out that both shops are partly talking their book. But the pair are unlikely bedfellows, making their joint enthusiasm interesting.

Although it has an under-appreciated active side — mostly sub-advised by the likes of Baillie Gifford, Wellington and PRIMECAP — Vanguard doesn’t really care what you invest in. It sucks up billions of dollars mostly through its fleet of dirt-cheap index funds.

Gramercy is the opposite, an EM-focused investment manager founded by former Lehman trader Robert Koenigsberger. It now has some long-only strategies, but in spirit it remains a hedge fund specialises in squeezing money out of debt disasters.

Vanguard makes much the same pro EM-credit argument as Gramercy. EM corporate fundamentals have proven “remarkably resilient” since the onset of the pandemic, while leverage across the asset class is at its lowest level in more than a decade.

Indeed, EM corporates have “stronger fundamentals” and less than half the net leverage of developed markets, which makes it odd that they’ve underperformed their US and European high yield equivalents so far this year. Gramercy detects a whiff of snobbery, suggesting investors may have penalised them “simply for being in the wrong zip code”.

EM default rates are low once you strip out Chinese property companies and anything based in Russia or Ukraine, and spreads are wider, too, as Gramercy points out:

EM IG and HY corporates currently trade at a spread per turn of net leverage of 239bps and 326bps, respectively.

This compares to 69bps and 132bps for U.S. IG and HY, respectively, and 27bps and 118bps for EUR IG and HY, respectively. This means that on a spread per turn of net leverage, investors are now paid 3.5x and 8.9x more to own EM IG vs U.S. IG or EUR IG, respectively. For HY, investors are paid 2.5x and 2.8x more to own EM HY vs U.S. HY and EUR HY, respectively.

You’d also be forgiven for thinking that rising interest rates and crazy macro volatility might hit EM companies harder than it would those in Europe and the US, for example.

Think again, says Gramercy. After all, DM corporates haven’t had to deal with high inflationary environments for decades. EM corporates, on the other hand “are used to operating through uncertain macroeconomic backdrops that include not only high inflation, but also stagflation, FX volatility”.

Analysts at John Hancock Investment Management broadly agree:

While the outlook for the global economy is far from rosy, the high-yield segment of EM corporates appears priced for calamity. After more than 200 basis points (bps) of year-to-date spread widening, the yield on the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified High Yield Index is now 10.3%. That level puts the current yield in the 99th percentile over the past 10 years, more than two standard deviations away from the long-term median and more than 325bps above that level.