Emerging Market Debt
November 2010
Emerging Market Debt: The Nascent Opportunity in Emerging Market Corporate Bonds
IN V EST M E N T M A N AG EMEN T
Table of Contents Emerging Markets in Ascendance
2
Corporate Credit Offers Opportunities
4
The Compelling Profile of Corporate Credit
7
Accessing the Opportunities in a Growing Market
1
12
Global investing has risen to new prominence as changes in the financial landscape have made the world more interconnected economically while simultaneously expanding the number of investment opportunities. Strategies that invest in bonds from a variety of jurisdictions are an effective way to generate higher returns and improved diversification while providing investment managers with an expanded opportunity set from which to source alpha. Due to ongoing structural trends, emerging market bonds — and emerging market corporate bonds, in particular — offer these benefits in the context of a much more supportive macroeconomic environment than the debt issued in many other parts of the world. Emerging market corporate debt has come into its own as a discrete asset class. Still limited in terms of ownership and research coverage, emerging corporate debt offers significant alpha opportunities as the fundamentals of the asset class continue to improve. In addition to an attractive risk/return profile and high average credit quality, emerging corporate debt historically has provided diversification benefits, particularly when combined with U.S. and global government bonds and, to some extent, equities.
Emerging Market Debt White Paper: November 2010
Emerging Markets in Ascendance Dramatic changes in the global economy in recent years have led us to believe that globalization is a permanent condition rather than a temporary set of circumstances. Reduced barriers to international trade and major advances in communications and transportation have catapulted commercial activity to unprecedented levels. World exports as a percentage of global GDP have doubled in the past 20 years. Financial accounting standards have been adopted around the world, and the important capital markets are now accessible to domestic and foreign investors alike. Individual investors with access to mutual funds and SICAVs1 can now consider opportunities formerly limited to large institutions. A too-often overlooked opportunity of the evolving global investment landscape has been the emerging debt markets. While the developed world was spending its way into bloated public balance sheets as governments fought off the Great Recession, emerging markets — which all along were less exposed to the factors that led to the financial crisis — were free to continue along a path of high growth, improving fundamentals and ongoing structural reform. At this point, the top eight emerging market countries — China, India, Brazil, Russia, Mexico, Korea, Indonesia and Taiwan — generate more than half of the world’s total GDP growth, as you can see in Figure 1. And given the shocking turnaround in fundamentals, there’s no reason to believe that this trend will not continue; for example, public debt to GDP as well as fiscal deficits are both far lower for emerging markets than for developed ones (Figures 2 and 3).
The top eight emerging market countries generate more than half of the world’s total GDP growth.
Figure 1. Emerging Markets Have Become Increasingly Important to World Growth Contribution to Global GDP Growth, on a Purchasing Power Parity Basis 70
Percent (%)
60 50 40 30 20 10
1990
1993
U.S. + E.U. + Japan
1996
1999
2002
2005
2008
2011
Top Eight Emerging Markets*
Source: Economist Intelligence Unit, ING Investment Management *China, India, Brazil, Russia, Mexico, Korea, Indonesia and Taiwan
1
S ociété d’Investissement à Capital Variable — open-ended investment vehicles common in Western Europe that are similar to mutual funds in the U.S.
Emerging Market Debt White Paper: November 2010
2
Figure 2. Emerging Markets Have Lower Public Debt Ratios… General Government Debt as % of GDP 100% 80% 60% 40% 20% 0%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 F F OECD Countries Emerging Markets
Source: Datastream, Organisation for Economic Co-operation and Development, Credit Suisse
Figure 3. …and Smaller Fiscal Deficits
A number of structural advances have further supported emerging market debt as a more mature asset class.
Fiscal Balances as % of GDP 2% 0% -2% -4% -6% -8% -10%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 F F G-7 Countries Emerging Markets
Source: Datastream, Economist Intelligence Unit, Credit Suisse
Beyond improved fundamentals, a number of structural advances have further supported emerging market debt as a more mature asset class. For one, local-currency debt far outweighs the level of hard-currency debt (that is, debt denominated in U.S. dollars or another widely accepted currency as opposed to the currency of the market in which the debt is issued) in the marketplace. Therefore, emerging markets are not reliant solely on outside funding. Diminished levels of foreign funding allow most emerging markets to avoid the classic currency mismatch problem — assets and liabilities denominated in different currencies, thus making a system highly vulnerable to exchange-rate fluctuations — that had plagued emerging markets in decades past.
3
Emerging Market Debt White Paper: November 2010
From an asset allocation perspective, emerging market bonds provide important diversification benefits to a fixed income portfolio. Both dollar-based and localcurrency bonds enjoy low correlations with U.S. and global government bonds and with equities (as shown in Figure 13 on page 11). Emerging bonds also provide strong risk-adjusted return characteristics, with attractive spread pickup over developed market sovereigns; emerging market corporate debt offers even higher yields than emerging sovereigns.
Corporate Credit Offers Opportunities As emerging markets have become more stable business environments over the past decade, corporations domiciled in those markets have looked increasingly to international capital markets for funding. JPMorgan estimates that corporations will account for roughly 70% of total emerging market bond issuance in 2010, up from just over half before the financial crisis. In fact, with $620 billion outstanding, corporate credits now comprise over 40% of the combined sovereign and corporate universes as measured by the JPMorgan Emerging Market Bond Index Global (EMBI) and the JPMorgan Corporate Emerging Market Bond Broad Index (CEMBI Broad), as shown in Figure 4; this compares to less than 15% as of 2002. This growth can be attributed to two main drivers. First, as emerging market economies have stabilized and matured, their sovereign funding needs have declined. This maturation has also enabled governments to meet more of their financing needs within their own deep and well-functioning local markets, allowing corporations to garner more attention on the international stage. At the same time, corporate issuance has expanded thanks to the growth of emerging market companies, their greater use of standard international accounting practices and an increased level of investor comfort with emerging companies (and vice versa).
JPMorgan estimates that corporate issuance will account for roughly 70% of total emerging market bond issuance in 2010.
Figure 4. Corporate Credit Continues to Increase Its Share of Total Emerging Market Debt... Emerging Market Corporate Credit as a Percentage of Total Emerging Market Credit 50% 40% 30% 20% 10% 0% 1/2002
1/2003
1/2004
1/2005
1/2006
1/2007
1/2008
1/2009
9/2010
Source: JPMorgan Note: Total emerging market credit is proxied by the combined market capitalization of the broadest sovereign and emerging corporate credit benchmarks — EMBI Global and CEMBI Broad, respectively. EM Corporate Credit is proxied by CEMBI Broad.
Emerging Market Debt White Paper: November 2010
4
Figure 5. ...and Has Overtaken Sovereign Debt in Terms of New Issuance 200
$ in Billions
150
100
50
0 2000
2001
2002
2003
Emerging Market Sovereigns
2004
2005
2006
2007
2008
2009
2010 YTD
2010 F
Emerging Market Corporates and Quasi-Sovereigns
Source: JPMorgan
Given the many attractive attributes of emerging corporates, there are reasons to believe that a larger number of investors will soon decide an allocation to emerging corporates is appropriate for their portfolios.
5
Non-sovereign primary issuance in the emerging markets averaged around $75 billion between 2000 and 2009 and $117 billion between 2006 and 2009; through the end of October, new issuance had already eclipsed $145 billion for 2010 and is expected to reach $180 billion before year end, exceeding earlier forecasts. Extrapolating those trends leads us to a conservative projection of 16–20% nominal growth in emerging market corporate credit over the medium term. Meanwhile, although the development of a dedicated investor base for emerging market corporate debt is still at an early stage, its growth has already improved the investability, liquidity and depth of the asset class. And given the many attractive attributes of emerging corporates — everything from an attractive risk/return profile to improving emerging market fundamentals — there are reasons to believe that a larger number of investors will soon decide an allocation to emerging corporates is appropriate for their portfolios.
Emerging Market Debt White Paper: November 2010
A Look at the Benchmark The introduction of a global emerging corporate credit family of indices by JPMorgan in 2007 (with a back-filled inception date at the end of 2002) provided a unique platform for both investors and asset managers to build separate and dedicated investment vehicles to tap into this growing sub-segment of the emerging markets fixed income universe. The JPMorgan Corporate Emerging Market Bond Index (CEMBI) family was launched as an extension of its popular Emerging Market Bond Index (EMBI) lineup and quickly gained acceptance among investors, becoming the industry standard for tracking the performance of dollar-denominated debt issued by corporations based in emerging markets. The least constrained version of the CEMBI series, the CEMBI Broad, has a total outstanding issue size of $335 billion as of end-October 2010 versus $420 billion for the EMBI Global (an unconstrained index tracking emerging market sovereign debt), and JPMorgan estimates that the CEMBI Broad will eclipse the EMBI Global in size within the next five years. We prefer to employ the CEMBI Diversified Index as a benchmark, as it provides investors with a larger, more liquid, more accessible subset of CEMBI credits and is well diversified from a regional standpoint. For a relatively new and growing asset class, emerging market corporates offer investors significant intra-class diversification. While Asian and Latin American issuers comprise the largest segment of the CEMBI Diversified, companies in Europe, the Middle East and Africa are also well represented; as you can see in Figure 6, the corporate index is more globally diversified than its sovereign counterpart, which is heavily weighted in Latin American issues. The CEMBI Diversified also offers investors broad exposure to variety of sectors, from banks and industrials to oil and telecoms. Also important to note is that the CEMBI Diversified is solidly investment grade in terms of credit quality, with an average rating of Baa1/BBB. Figure 6. Comparison of CEMBI Diversified with EMBI Global Diversified As of October 29, 2010 CEMBI Diversified By Rating
By Sector
By Region Average = Baa1/BBB Residual B BB Investment Grade
Utilities Telecom Oil Metals & Mining Industrials Consumer Products Banks
Middle East Latin America Europe Asia Africa
EMBI Global Diversified By Rating
By Region Average = Ba1/BB+ Residual B BB Investment Grade
By Sector Middle East Latin America Europe Asia Africa
Sovereign
Source: JPMorgan
Emerging Market Debt White Paper: November 2010
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The Compelling Profile of Corporate Credit Figure 7 provides a snapshot of how emerging corporates stack up against other fixed income asset classes across several key metrics. Figure 7. Emerging Corporate Credit Has an Attractive Profile As of September 20, 2010 Barclays U.S. Treasury
Barclays Barclays U.S. U.S. HY Corporates 2% cap
GBI-EM EMBI Global Global Diversified Diversified
CEMBI Diversified
Duration
5.5
6.7
4.2
7.1
4.4
5.9
Average Maturity
6.8
10.3
6.8
11.3
6.2
9.2
Average Spread
7.0
175.0
660.0
303.0
na
358.0
Yield to Maturity
1.5
3.8
8.3
5.7
5.9
5.8
Currency
USD
USD
USD
USD/EUR
Local
USD/EUR
Source: JPMorgan, Barclays Capital, ING Investment Management
Emerging market corporate bonds historically have offered attractive spreads relative to developed market credits of similar ratings.
Duration. The duration of the CEMBI Diversified Index is 5.9 years. This is comparable to the duration of U.S. Treasuries, higher than that of high yield issues and lower than that of emerging market sovereigns. Yield. Investors looking for yield in the current low-rate environment may be inclined to overweight the corporate bonds — both investment grade and high yield — of developed market issuers. Emerging market corporates would also be an appropriate investment option to meet this tactical positioning; as of September 20, 2010, emerging market corporates offer a yield of 5.76%, better than the 3.78% of U.S. investment grade bonds. Although emerging corporate yields are below the 8.32% of U.S. high yield securities, this can be attributed to differences in credit quality and duration, as spreads for non-investment grade emerging corporates have been higher than those for U.S. high yield. Spread. As shown in Figure 8, emerging market corporate bonds historically have offered attractive spreads relative to developed market credits of similar ratings across the quality spectrum. This relationship continues to exist. For example, as of October 30, 2010, investment grade emerging market corporates offered 103 basis points of excess spread relative to investment grade U.S. corporates and 79 basis points relative to investment grade emerging market sovereigns. Moreover, this excess spread comes with a higher average credit quality: A3/Afor emerging corporates versus Baa2/BBB for U.S. corporates and emerging market sovereigns. Moving down in credit quality, the excess spread, at 165 basis points, is even more pronounced at the BB level when compared to emerging market sovereigns.
7
Emerging Market Debt White Paper: November 2010
Figure 8. Emerging Corporates Offer Compelling Spreads Across Credit Qualities Average Spread — Investment Grade 800
Basis Points
700 600 500 400 300 200 100 0
3Q02
3Q03
U.S. Corporates
3Q04
3Q05
EMBI
3Q06
3Q07
3Q08
3Q09
3Q10
CEMBI
The emerging corporates benchmark features a greater proportion of investment grade issues than the emerging sovereign benchmark.
Average Spread — BB Rated 2,000
Basis Points
1,500
1,000
500
0
3Q02
3Q03
U.S. Corporates
3Q04 EMBI
3Q05
3Q06
3Q07
3Q08
3Q09
3Q10
CEMBI
Source: JPMorgan, Barclays Capital, ING Investment Management Note: Spreads are estimated using the following benchmarks: JPMorgan CEMBI Diversified, JPMorgan EMBI Global Diversified and Barclays High Yield with 2% issue cap.
Credit quality. The emerging corporates benchmark features a greater proportion of investment grade issues than the emerging sovereign benchmark; as shown in Figure 9, more than 70% of the CEMBI Diversified carries an investment grade rating compared to 56% of the EMBI as of September 2010. In addition, the CEMBI Diversified will also carry credits rated A and higher, which makes the average rating Baa1/BBB. Historically, the corporate credit index contained an even larger share of investment grade issues; while market dynamics may cause this deterioration in credit quality to continue, long-term structural improvements in emerging market economies should offset this somewhat. Moreover, default
Emerging Market Debt White Paper: November 2010
8
rates among emerging market corporate issuers — measured by JPMorgan as defaults by high yield issuers within the emerging corporate universe — have on average been lower than those of U.S. high yield bonds (see Figure 10). JPMorgan does not compare investment grade defaults, as no investment grade emerging market corporate has defaulted in a given calendar year since at least January 2003. Figure 9. CEMBI Is Heavily Weighted in High-Quality Issues As of September 20, 2010 100% 80% 60% 40% 20% 0%
Barclays U.S. HY
Lower
B
BB
EMBI Global Diversified
CEMBI Diversified
IG
Source: JPMorgan, Barclays Capital, ING Investment Management
Figure 10. Emerging Corporate Default Rates Compare Favorably to the U.S. Market In Percent
EM
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1.8
6.1
15.4
3.5
0.8
0.2
0.4
0.2
2.0
11.5
2.1
5.5
2.5
2.0
1.3
1.0
4.0
10.3
2.0
As of September U.S. 7.3 10.520, 2010 7.1
2010 E
100% Source: Standard & Poor’s, JPMorgan 80%
If 60% you take a look at the fundamentals of the companies represented in the CEMBI relative to their developed-market peers, it’s easy to see this credit-quality advan40%continuing. Figure 11 looks at selected fundamental metrics of eight oil comtage panies 20% of various sizes and credit ratings: five based in emerging markets and three from the developed markets. As you can see, the emerging market companies in this0% example are U.S. wellHYpositioned relative to theirCEMBI developed market peers; low costs Barclays EMBI Global Diversified Diversified CEMBI Broad enable these emerging market oil companies to maintain high profit margins and Lower BB generate ampleBfree cash flowIGversus their relatively lower debt. Similar examples of robust corporate structures can be found in other emerging market sectors.
9
Emerging Market Debt White Paper: November 2010
Figure 11. Emerging Corporates Feature Compelling Fundamentals In US$ Millions Emerging Markets Lukoil
Petrobras Gazprom
Developed Markets Marathon ConocoOil phillips Occidental
TNK-BP
Petronas
Revenue
68,025
92,595
141,976
31,172
56,755
48,474
149,341
15,403
EBITDA
14,096
29,856
62,709
8,127
21,203
5,472
17,606
7,993
Cash
2,274
1,578
11,694
328
34,818
2,057
542
1,230
Debt
11,323
57,170
46,446
2,225
15,653
8,532
28,653
2,796
Equity
55,991
91,541
156,622
19,418
66,389
21,910
62,467
29,081
S&P
BBB-
BBB-
BBB
BBB-
A-
BBB+
A
A
Moody's
Baa2
Baa1
Baa1
Baa2
A1
Baa1
A1
A2
EBITDA/ Revenue
21%
32%
44%
26%
37%
11%
12%
52%
EBITDA/ Interest
21.1
12.4
25.9
71.3
23.7
10.7
13.7
57.1
CFO/Net Debt
98%
47%
118%
402%
*
81%
44%
371%
FCF/Net Debt
27%
47%
35%
277%
*
-15%
6%
143%
Net Debt/ EBITDA
64%
186%
55%
23%
*
118%
160%
20%
Source: Bloomberg, company reports * Data not meaningful as net debt is negative.
Performance. From 2003 through September 2010, emerging corporate bonds have delivered an average annual total return of 8.6%. The volatility of the asset class, at 11.7% over the same period, is similar to that of U.S. high yield bonds and emerging local bonds but with a higher average credit quality. In terms of riskadjusted return (Sharpe ratio), emerging market corporates compare favorably with developed market fixed income assets. The investor acceptance of emerging market corporate debt as an asset class has been slow due to the impact of home bias and other factors; as the investor base for the asset class expands in line with improving fundamentals and eventual credit rating upgrades, risk-adjusted performance for the asset class can be expected to improve over time. High excess risk premiums support high excess return potential, while volatility should decrease over time in line with a broader investor base.
The investor acceptance of emerging market corporate debt as an asset class has been slow due to the impact of home bias and other factors.
Correlation. Historical correlation analysis shows that emerging corporates have diversifying properties when combined with developed government and corporate bonds and, to some extent, with equities.
Emerging Market Debt White Paper: November 2010
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Figure 12. Emerging Corporates Offer High Credit Quality and Competitive Returns... January 2003 through October 2010 CEMBI Diversified
EMBI Global GBI EM Global Diversified Diversified
Developed Barclays U.S. Barclays U.S. Barclays U.S. Gov't Bonds Treasury Corporates High Yield
MSCI World
MSCI EM
2003
11.56%
21.73%
16.46%
15.34%
14.46%
2.07%
8.11%
29.01%
33.24%
55.67%
2004
9.46%
11.18%
22.49%
14.34%
9.92%
3.25%
5.11%
10.83%
14.79%
25.46%
2005
6.42%
9.82%
5.85%
2.80%
-7.24%
2.46%
1.36%
2.46%
9.59%
34.01%
2006
6.23%
9.43%
14.77%
11.86%
5.70%
2.72%
3.96%
11.49%
20.18%
32.07%
2007
3.05%
5.74%
17.64%
15.59%
10.52%
8.69%
4.20%
1.65%
9.14%
39.23%
2008
-15.69%
-12.38%
-5.60%
-4.22%
10.46%
13.60%
-4.49%
-24.46%
-40.57%
-53.36%
2009
38.07%
29.31%
21.51%
11.26%
2.15%
-3.81%
18.61%
60.18%
30.28%
78.32%
2010
11.04%
12.18%
9.52%
-0.07%
4.29%
8.52%
9.82%
8.22%
-6.06%
-0.35%
8.6%
10.7%
13.1%
8.5%
6.4%
4.8%
5.9%
10.7%
6.3%
19.8%
BBB/Baa1
BB+/Ba1
BBB+
A
AA1/AA2
AAA/AAA
A2/A3
B1/B2
n/a
n/a
11.6%
9.8%
11.6%
7.4%
7.5%
5.0%
6.8%
11.5%
16.7%
25.3%
Information Ratio
0.70
1.10
1.13
1.14
0.84
0.95
0.87
0.93
0.38
0.78
Sharpe Ratio
0.50
0.81
0.89
0.77
0.47
0.40
0.46
0.69
0.21
0.67
Skewness
-3.61
-3.17
-1.23
-1.44
-0.04
-0.20
-0.94
-1.34
-1.35
-1.34
Annualized Return Rating Volatility
ELMI+
Kurtosis
26.71
22.29
8.42
7.81
3.27
4.97
8.06
11.65
7.10
7.19
Maximum Drawdown
-31%
-23%
-25%
-21%
-9%
-5%
-15%
-33%
-56%
-66%
VaR (99%)
7.2%
5.7%
6.7%
4.3%
4.5%
3.0%
4.1%
6.8%
10.7%
15.3%
Source: Datastream
Figure 13. ...as Well as Attractive Diversification Benefits January 31, 2003, through August 31, 2010 Correlation with CEMBI Diversified EMBI Global Diversified
1.0
GBI EM Global Diversified
0.7
ELMI +
0.6
Datastream Global Gov’t Bonds
0.4
Barclays U.S. Treasuries
0.3
Barclays U.S. Corporates
0.9
Barclays U.S. High Yield with 2% issue cap
0.7
MSCI World
0.6
MSCI Emerging Markets
0.6
Source: JPMorgan, Barclays Capital, Datastream, ING Investment Management
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Emerging Market Debt White Paper: November 2010
Accessing the Opportunities in a Growing Market Despite the unequivocal evidence of the growing importance of emerging economies, the outstanding corporate debt stock of emerging markets is equal to only around 1.3% of global outstanding debt. As the market continues to grow over the next ten years to a level more consistent with the contribution of emerging markets to the world economy, we expect this figure to approach 5.75%; this assumes that an average growth rate of 16% for the asset class based on historical primary issuance trends. The market’s expansion will likely draw greater attention to the asset class, and Figure 14 highlights the benefits that may be possible with only a small allocation to emerging corporates. By simply diverting 10% of a global fixed income portfolio’s assets from the Barclays Global Aggregate to an emerging corporates mandate, an investor historically would have picked up an additional 45 basis points of annualized return with slightly less volatility. The same 10% reallocation away from an all-U.S. bond portfolio would have generated a similar uptick in return, though with slightly more volatility. In addition, an increase in investor demand may result in a decline in volatility, further supporting the argument in favor of an allocation to emerging corporates.
Despite the potential of the asset class, corporate emerging market bonds are not widely available as a standalone investment.
Figure 14. A Small Allocation to Emerging Corporates Can Have a Big Impact December 31, 2001, through October 29, 2010 Annualized Return
Annualized Standard Deviation
Barclays Global Aggregate
7.45%
Barclays Global Aggregate
6.35%
Barclays U.S. Aggregate
5.74%
Barclays U.S. Aggregate
3.85%
CEMBI
8.45%
CEMBI
90% Global Ag/10% CEMBI
7.90%
90% Global Ag/10% CEMBI
6.26%
90% U.S. Ag/10% CEMBI
6.17%
90% U.S. Ag/10% CEMBI
4.14%
10.03%
Source: JPMorgan, Barclays Capital
Deciding to make an allocation to emerging market corporate debt based only on its historical performance, however, is complicated by the fact that the asset class is still in the development stage, and we only have limited history available. We believe the structure of the asset class will change to incorporate more non-investment grade bonds as these types of issuers gain better access to the market. At the same time, improving economic fundamentals in emerging markets suggest that many non-investment grade issuers have a good chance of graduating into better ratings, which should also generate positive return dynamics for early investors. Despite the potential of the asset class, corporate emerging market bonds are not widely available as a standalone investment; typically, investors who desire emerging corporate exposure are forced to invest in a broad emerging market debt product that consists mainly of sovereigns and tends to pay limited attention to managing corporate risk. JPMorgan estimates that as of September 2010, there were about $15 billion of CEMBI-benchmarked funds under management, with
Emerging Market Debt White Paper: November 2010
12
only $7–8 billion of it in CEMBI-only mandates and the rest in blended strategies. JPMorgan puts the number of investment managers in the emerging corporates space at about a dozen, compared with nearly 50 involved with emerging bonds in general.
For an investment manager to be successful in this space, research is critical.
13
However, select CEMBI-focused vehicles are beginning to appear — assets under management should reach $20 billion by the end of 2010 according to JPMorgan — affording investors both the option of an alternative asset in the credit spectrum and the ability to make a straightforward relative value assessment and allocation decision versus developed market investment grade and high yield corporate credits. For an investment manager to be successful in this space, research is critical. Though they have improved significantly in recent years, emerging markets are still far less mature than developed ones — meaning that corporate information may be more difficult to access, disclosure may vary in terms of quality and volume, and country/political/corporate governance factors play a significant role. A manager with a strong track record of investing in emerging market sovereigns and a deep understanding of the individual economic regimes would be at an advantage. Further, a manager with a strong local presence across multiple jurisdictions will be best positioned to develop the information advantages that lead to alpha generation.
Emerging Market Debt White Paper: November 2010
Conclusion Although still relatively underutilized, emerging market debt has been steadily growing in popularity in recent years as investors search for yield in a world of rock-bottom interest rates. However, emerging sovereigns may lose some of their high-yielding appeal as the underlying credit dynamics in developed and emerging nations continue to converge, forcing spreads to tighten. In such an environment, new — but similar — exposures like emerging market corporate debt could make up for the lost appeal of sovereigns. Emerging market corporates offer diversification benefits not unlike those of emerging market government bonds, but with a higher return potential and better credit quality. This is due both to the added yield corporates offer relative to sovereigns as well as the alpha potential inherent in such an under-researched/under-owned asset class. Given the growing importance of emerging markets to the global economy and the increasing stability of these countries, we think now is a good time for investors in all domiciles to consider allocating a portion of their diversified fixed income portfolios to the debt of emerging market corporations.
Emerging Market Debt White Paper: November 2010
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This review has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. The material presented is compiled from sources thought to be reliable, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. ©2010 ING Investments Distributor, LLC • 230 Park Avenue, New York, NY 10169
www.ingINVESTMENT.com
BSWP-CEMD1110 (1101-110110 ex013112)
Emerging Market Debt: The Nascent Opportunity in Emerging Market Corporate Bonds
IN V EST M E N T M A N AG EMEN T
Table of Contents Emerging Markets in Ascendance
2
Corporate Credit Offers Opportunities
4
The Compelling Profile of Corporate Credit
7
Accessing the Opportunities in a Growing Market
1
12
Global investing has risen to new prominence as changes in the financial landscape have made the world more interconnected economically while simultaneously expanding the number of investment opportunities. Strategies that invest in bonds from a variety of jurisdictions are an effective way to generate higher returns and improved diversification while providing investment managers with an expanded opportunity set from which to source alpha. Due to ongoing structural trends, emerging market bonds — and emerging market corporate bonds, in particular — offer these benefits in the context of a much more supportive macroeconomic environment than the debt issued in many other parts of the world. Emerging market corporate debt has come into its own as a discrete asset class. Still limited in terms of ownership and research coverage, emerging corporate debt offers significant alpha opportunities as the fundamentals of the asset class continue to improve. In addition to an attractive risk/return profile and high average credit quality, emerging corporate debt historically has provided diversification benefits, particularly when combined with U.S. and global government bonds and, to some extent, equities.
Emerging Market Debt White Paper: November 2010
Emerging Markets in Ascendance Dramatic changes in the global economy in recent years have led us to believe that globalization is a permanent condition rather than a temporary set of circumstances. Reduced barriers to international trade and major advances in communications and transportation have catapulted commercial activity to unprecedented levels. World exports as a percentage of global GDP have doubled in the past 20 years. Financial accounting standards have been adopted around the world, and the important capital markets are now accessible to domestic and foreign investors alike. Individual investors with access to mutual funds and SICAVs1 can now consider opportunities formerly limited to large institutions. A too-often overlooked opportunity of the evolving global investment landscape has been the emerging debt markets. While the developed world was spending its way into bloated public balance sheets as governments fought off the Great Recession, emerging markets — which all along were less exposed to the factors that led to the financial crisis — were free to continue along a path of high growth, improving fundamentals and ongoing structural reform. At this point, the top eight emerging market countries — China, India, Brazil, Russia, Mexico, Korea, Indonesia and Taiwan — generate more than half of the world’s total GDP growth, as you can see in Figure 1. And given the shocking turnaround in fundamentals, there’s no reason to believe that this trend will not continue; for example, public debt to GDP as well as fiscal deficits are both far lower for emerging markets than for developed ones (Figures 2 and 3).
The top eight emerging market countries generate more than half of the world’s total GDP growth.
Figure 1. Emerging Markets Have Become Increasingly Important to World Growth Contribution to Global GDP Growth, on a Purchasing Power Parity Basis 70
Percent (%)
60 50 40 30 20 10
1990
1993
U.S. + E.U. + Japan
1996
1999
2002
2005
2008
2011
Top Eight Emerging Markets*
Source: Economist Intelligence Unit, ING Investment Management *China, India, Brazil, Russia, Mexico, Korea, Indonesia and Taiwan
1
S ociété d’Investissement à Capital Variable — open-ended investment vehicles common in Western Europe that are similar to mutual funds in the U.S.
Emerging Market Debt White Paper: November 2010
2
Figure 2. Emerging Markets Have Lower Public Debt Ratios… General Government Debt as % of GDP 100% 80% 60% 40% 20% 0%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 F F OECD Countries Emerging Markets
Source: Datastream, Organisation for Economic Co-operation and Development, Credit Suisse
Figure 3. …and Smaller Fiscal Deficits
A number of structural advances have further supported emerging market debt as a more mature asset class.
Fiscal Balances as % of GDP 2% 0% -2% -4% -6% -8% -10%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 F F G-7 Countries Emerging Markets
Source: Datastream, Economist Intelligence Unit, Credit Suisse
Beyond improved fundamentals, a number of structural advances have further supported emerging market debt as a more mature asset class. For one, local-currency debt far outweighs the level of hard-currency debt (that is, debt denominated in U.S. dollars or another widely accepted currency as opposed to the currency of the market in which the debt is issued) in the marketplace. Therefore, emerging markets are not reliant solely on outside funding. Diminished levels of foreign funding allow most emerging markets to avoid the classic currency mismatch problem — assets and liabilities denominated in different currencies, thus making a system highly vulnerable to exchange-rate fluctuations — that had plagued emerging markets in decades past.
3
Emerging Market Debt White Paper: November 2010
From an asset allocation perspective, emerging market bonds provide important diversification benefits to a fixed income portfolio. Both dollar-based and localcurrency bonds enjoy low correlations with U.S. and global government bonds and with equities (as shown in Figure 13 on page 11). Emerging bonds also provide strong risk-adjusted return characteristics, with attractive spread pickup over developed market sovereigns; emerging market corporate debt offers even higher yields than emerging sovereigns.
Corporate Credit Offers Opportunities As emerging markets have become more stable business environments over the past decade, corporations domiciled in those markets have looked increasingly to international capital markets for funding. JPMorgan estimates that corporations will account for roughly 70% of total emerging market bond issuance in 2010, up from just over half before the financial crisis. In fact, with $620 billion outstanding, corporate credits now comprise over 40% of the combined sovereign and corporate universes as measured by the JPMorgan Emerging Market Bond Index Global (EMBI) and the JPMorgan Corporate Emerging Market Bond Broad Index (CEMBI Broad), as shown in Figure 4; this compares to less than 15% as of 2002. This growth can be attributed to two main drivers. First, as emerging market economies have stabilized and matured, their sovereign funding needs have declined. This maturation has also enabled governments to meet more of their financing needs within their own deep and well-functioning local markets, allowing corporations to garner more attention on the international stage. At the same time, corporate issuance has expanded thanks to the growth of emerging market companies, their greater use of standard international accounting practices and an increased level of investor comfort with emerging companies (and vice versa).
JPMorgan estimates that corporate issuance will account for roughly 70% of total emerging market bond issuance in 2010.
Figure 4. Corporate Credit Continues to Increase Its Share of Total Emerging Market Debt... Emerging Market Corporate Credit as a Percentage of Total Emerging Market Credit 50% 40% 30% 20% 10% 0% 1/2002
1/2003
1/2004
1/2005
1/2006
1/2007
1/2008
1/2009
9/2010
Source: JPMorgan Note: Total emerging market credit is proxied by the combined market capitalization of the broadest sovereign and emerging corporate credit benchmarks — EMBI Global and CEMBI Broad, respectively. EM Corporate Credit is proxied by CEMBI Broad.
Emerging Market Debt White Paper: November 2010
4
Figure 5. ...and Has Overtaken Sovereign Debt in Terms of New Issuance 200
$ in Billions
150
100
50
0 2000
2001
2002
2003
Emerging Market Sovereigns
2004
2005
2006
2007
2008
2009
2010 YTD
2010 F
Emerging Market Corporates and Quasi-Sovereigns
Source: JPMorgan
Given the many attractive attributes of emerging corporates, there are reasons to believe that a larger number of investors will soon decide an allocation to emerging corporates is appropriate for their portfolios.
5
Non-sovereign primary issuance in the emerging markets averaged around $75 billion between 2000 and 2009 and $117 billion between 2006 and 2009; through the end of October, new issuance had already eclipsed $145 billion for 2010 and is expected to reach $180 billion before year end, exceeding earlier forecasts. Extrapolating those trends leads us to a conservative projection of 16–20% nominal growth in emerging market corporate credit over the medium term. Meanwhile, although the development of a dedicated investor base for emerging market corporate debt is still at an early stage, its growth has already improved the investability, liquidity and depth of the asset class. And given the many attractive attributes of emerging corporates — everything from an attractive risk/return profile to improving emerging market fundamentals — there are reasons to believe that a larger number of investors will soon decide an allocation to emerging corporates is appropriate for their portfolios.
Emerging Market Debt White Paper: November 2010
A Look at the Benchmark The introduction of a global emerging corporate credit family of indices by JPMorgan in 2007 (with a back-filled inception date at the end of 2002) provided a unique platform for both investors and asset managers to build separate and dedicated investment vehicles to tap into this growing sub-segment of the emerging markets fixed income universe. The JPMorgan Corporate Emerging Market Bond Index (CEMBI) family was launched as an extension of its popular Emerging Market Bond Index (EMBI) lineup and quickly gained acceptance among investors, becoming the industry standard for tracking the performance of dollar-denominated debt issued by corporations based in emerging markets. The least constrained version of the CEMBI series, the CEMBI Broad, has a total outstanding issue size of $335 billion as of end-October 2010 versus $420 billion for the EMBI Global (an unconstrained index tracking emerging market sovereign debt), and JPMorgan estimates that the CEMBI Broad will eclipse the EMBI Global in size within the next five years. We prefer to employ the CEMBI Diversified Index as a benchmark, as it provides investors with a larger, more liquid, more accessible subset of CEMBI credits and is well diversified from a regional standpoint. For a relatively new and growing asset class, emerging market corporates offer investors significant intra-class diversification. While Asian and Latin American issuers comprise the largest segment of the CEMBI Diversified, companies in Europe, the Middle East and Africa are also well represented; as you can see in Figure 6, the corporate index is more globally diversified than its sovereign counterpart, which is heavily weighted in Latin American issues. The CEMBI Diversified also offers investors broad exposure to variety of sectors, from banks and industrials to oil and telecoms. Also important to note is that the CEMBI Diversified is solidly investment grade in terms of credit quality, with an average rating of Baa1/BBB. Figure 6. Comparison of CEMBI Diversified with EMBI Global Diversified As of October 29, 2010 CEMBI Diversified By Rating
By Sector
By Region Average = Baa1/BBB Residual B BB Investment Grade
Utilities Telecom Oil Metals & Mining Industrials Consumer Products Banks
Middle East Latin America Europe Asia Africa
EMBI Global Diversified By Rating
By Region Average = Ba1/BB+ Residual B BB Investment Grade
By Sector Middle East Latin America Europe Asia Africa
Sovereign
Source: JPMorgan
Emerging Market Debt White Paper: November 2010
6
The Compelling Profile of Corporate Credit Figure 7 provides a snapshot of how emerging corporates stack up against other fixed income asset classes across several key metrics. Figure 7. Emerging Corporate Credit Has an Attractive Profile As of September 20, 2010 Barclays U.S. Treasury
Barclays Barclays U.S. U.S. HY Corporates 2% cap
GBI-EM EMBI Global Global Diversified Diversified
CEMBI Diversified
Duration
5.5
6.7
4.2
7.1
4.4
5.9
Average Maturity
6.8
10.3
6.8
11.3
6.2
9.2
Average Spread
7.0
175.0
660.0
303.0
na
358.0
Yield to Maturity
1.5
3.8
8.3
5.7
5.9
5.8
Currency
USD
USD
USD
USD/EUR
Local
USD/EUR
Source: JPMorgan, Barclays Capital, ING Investment Management
Emerging market corporate bonds historically have offered attractive spreads relative to developed market credits of similar ratings.
Duration. The duration of the CEMBI Diversified Index is 5.9 years. This is comparable to the duration of U.S. Treasuries, higher than that of high yield issues and lower than that of emerging market sovereigns. Yield. Investors looking for yield in the current low-rate environment may be inclined to overweight the corporate bonds — both investment grade and high yield — of developed market issuers. Emerging market corporates would also be an appropriate investment option to meet this tactical positioning; as of September 20, 2010, emerging market corporates offer a yield of 5.76%, better than the 3.78% of U.S. investment grade bonds. Although emerging corporate yields are below the 8.32% of U.S. high yield securities, this can be attributed to differences in credit quality and duration, as spreads for non-investment grade emerging corporates have been higher than those for U.S. high yield. Spread. As shown in Figure 8, emerging market corporate bonds historically have offered attractive spreads relative to developed market credits of similar ratings across the quality spectrum. This relationship continues to exist. For example, as of October 30, 2010, investment grade emerging market corporates offered 103 basis points of excess spread relative to investment grade U.S. corporates and 79 basis points relative to investment grade emerging market sovereigns. Moreover, this excess spread comes with a higher average credit quality: A3/Afor emerging corporates versus Baa2/BBB for U.S. corporates and emerging market sovereigns. Moving down in credit quality, the excess spread, at 165 basis points, is even more pronounced at the BB level when compared to emerging market sovereigns.
7
Emerging Market Debt White Paper: November 2010
Figure 8. Emerging Corporates Offer Compelling Spreads Across Credit Qualities Average Spread — Investment Grade 800
Basis Points
700 600 500 400 300 200 100 0
3Q02
3Q03
U.S. Corporates
3Q04
3Q05
EMBI
3Q06
3Q07
3Q08
3Q09
3Q10
CEMBI
The emerging corporates benchmark features a greater proportion of investment grade issues than the emerging sovereign benchmark.
Average Spread — BB Rated 2,000
Basis Points
1,500
1,000
500
0
3Q02
3Q03
U.S. Corporates
3Q04 EMBI
3Q05
3Q06
3Q07
3Q08
3Q09
3Q10
CEMBI
Source: JPMorgan, Barclays Capital, ING Investment Management Note: Spreads are estimated using the following benchmarks: JPMorgan CEMBI Diversified, JPMorgan EMBI Global Diversified and Barclays High Yield with 2% issue cap.
Credit quality. The emerging corporates benchmark features a greater proportion of investment grade issues than the emerging sovereign benchmark; as shown in Figure 9, more than 70% of the CEMBI Diversified carries an investment grade rating compared to 56% of the EMBI as of September 2010. In addition, the CEMBI Diversified will also carry credits rated A and higher, which makes the average rating Baa1/BBB. Historically, the corporate credit index contained an even larger share of investment grade issues; while market dynamics may cause this deterioration in credit quality to continue, long-term structural improvements in emerging market economies should offset this somewhat. Moreover, default
Emerging Market Debt White Paper: November 2010
8
rates among emerging market corporate issuers — measured by JPMorgan as defaults by high yield issuers within the emerging corporate universe — have on average been lower than those of U.S. high yield bonds (see Figure 10). JPMorgan does not compare investment grade defaults, as no investment grade emerging market corporate has defaulted in a given calendar year since at least January 2003. Figure 9. CEMBI Is Heavily Weighted in High-Quality Issues As of September 20, 2010 100% 80% 60% 40% 20% 0%
Barclays U.S. HY
Lower
B
BB
EMBI Global Diversified
CEMBI Diversified
IG
Source: JPMorgan, Barclays Capital, ING Investment Management
Figure 10. Emerging Corporate Default Rates Compare Favorably to the U.S. Market In Percent
EM
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
1.8
6.1
15.4
3.5
0.8
0.2
0.4
0.2
2.0
11.5
2.1
5.5
2.5
2.0
1.3
1.0
4.0
10.3
2.0
As of September U.S. 7.3 10.520, 2010 7.1
2010 E
100% Source: Standard & Poor’s, JPMorgan 80%
If 60% you take a look at the fundamentals of the companies represented in the CEMBI relative to their developed-market peers, it’s easy to see this credit-quality advan40%continuing. Figure 11 looks at selected fundamental metrics of eight oil comtage panies 20% of various sizes and credit ratings: five based in emerging markets and three from the developed markets. As you can see, the emerging market companies in this0% example are U.S. wellHYpositioned relative to theirCEMBI developed market peers; low costs Barclays EMBI Global Diversified Diversified CEMBI Broad enable these emerging market oil companies to maintain high profit margins and Lower BB generate ampleBfree cash flowIGversus their relatively lower debt. Similar examples of robust corporate structures can be found in other emerging market sectors.
9
Emerging Market Debt White Paper: November 2010
Figure 11. Emerging Corporates Feature Compelling Fundamentals In US$ Millions Emerging Markets Lukoil
Petrobras Gazprom
Developed Markets Marathon ConocoOil phillips Occidental
TNK-BP
Petronas
Revenue
68,025
92,595
141,976
31,172
56,755
48,474
149,341
15,403
EBITDA
14,096
29,856
62,709
8,127
21,203
5,472
17,606
7,993
Cash
2,274
1,578
11,694
328
34,818
2,057
542
1,230
Debt
11,323
57,170
46,446
2,225
15,653
8,532
28,653
2,796
Equity
55,991
91,541
156,622
19,418
66,389
21,910
62,467
29,081
S&P
BBB-
BBB-
BBB
BBB-
A-
BBB+
A
A
Moody's
Baa2
Baa1
Baa1
Baa2
A1
Baa1
A1
A2
EBITDA/ Revenue
21%
32%
44%
26%
37%
11%
12%
52%
EBITDA/ Interest
21.1
12.4
25.9
71.3
23.7
10.7
13.7
57.1
CFO/Net Debt
98%
47%
118%
402%
*
81%
44%
371%
FCF/Net Debt
27%
47%
35%
277%
*
-15%
6%
143%
Net Debt/ EBITDA
64%
186%
55%
23%
*
118%
160%
20%
Source: Bloomberg, company reports * Data not meaningful as net debt is negative.
Performance. From 2003 through September 2010, emerging corporate bonds have delivered an average annual total return of 8.6%. The volatility of the asset class, at 11.7% over the same period, is similar to that of U.S. high yield bonds and emerging local bonds but with a higher average credit quality. In terms of riskadjusted return (Sharpe ratio), emerging market corporates compare favorably with developed market fixed income assets. The investor acceptance of emerging market corporate debt as an asset class has been slow due to the impact of home bias and other factors; as the investor base for the asset class expands in line with improving fundamentals and eventual credit rating upgrades, risk-adjusted performance for the asset class can be expected to improve over time. High excess risk premiums support high excess return potential, while volatility should decrease over time in line with a broader investor base.
The investor acceptance of emerging market corporate debt as an asset class has been slow due to the impact of home bias and other factors.
Correlation. Historical correlation analysis shows that emerging corporates have diversifying properties when combined with developed government and corporate bonds and, to some extent, with equities.
Emerging Market Debt White Paper: November 2010
10
Figure 12. Emerging Corporates Offer High Credit Quality and Competitive Returns... January 2003 through October 2010 CEMBI Diversified
EMBI Global GBI EM Global Diversified Diversified
Developed Barclays U.S. Barclays U.S. Barclays U.S. Gov't Bonds Treasury Corporates High Yield
MSCI World
MSCI EM
2003
11.56%
21.73%
16.46%
15.34%
14.46%
2.07%
8.11%
29.01%
33.24%
55.67%
2004
9.46%
11.18%
22.49%
14.34%
9.92%
3.25%
5.11%
10.83%
14.79%
25.46%
2005
6.42%
9.82%
5.85%
2.80%
-7.24%
2.46%
1.36%
2.46%
9.59%
34.01%
2006
6.23%
9.43%
14.77%
11.86%
5.70%
2.72%
3.96%
11.49%
20.18%
32.07%
2007
3.05%
5.74%
17.64%
15.59%
10.52%
8.69%
4.20%
1.65%
9.14%
39.23%
2008
-15.69%
-12.38%
-5.60%
-4.22%
10.46%
13.60%
-4.49%
-24.46%
-40.57%
-53.36%
2009
38.07%
29.31%
21.51%
11.26%
2.15%
-3.81%
18.61%
60.18%
30.28%
78.32%
2010
11.04%
12.18%
9.52%
-0.07%
4.29%
8.52%
9.82%
8.22%
-6.06%
-0.35%
8.6%
10.7%
13.1%
8.5%
6.4%
4.8%
5.9%
10.7%
6.3%
19.8%
BBB/Baa1
BB+/Ba1
BBB+
A
AA1/AA2
AAA/AAA
A2/A3
B1/B2
n/a
n/a
11.6%
9.8%
11.6%
7.4%
7.5%
5.0%
6.8%
11.5%
16.7%
25.3%
Information Ratio
0.70
1.10
1.13
1.14
0.84
0.95
0.87
0.93
0.38
0.78
Sharpe Ratio
0.50
0.81
0.89
0.77
0.47
0.40
0.46
0.69
0.21
0.67
Skewness
-3.61
-3.17
-1.23
-1.44
-0.04
-0.20
-0.94
-1.34
-1.35
-1.34
Annualized Return Rating Volatility
ELMI+
Kurtosis
26.71
22.29
8.42
7.81
3.27
4.97
8.06
11.65
7.10
7.19
Maximum Drawdown
-31%
-23%
-25%
-21%
-9%
-5%
-15%
-33%
-56%
-66%
VaR (99%)
7.2%
5.7%
6.7%
4.3%
4.5%
3.0%
4.1%
6.8%
10.7%
15.3%
Source: Datastream
Figure 13. ...as Well as Attractive Diversification Benefits January 31, 2003, through August 31, 2010 Correlation with CEMBI Diversified EMBI Global Diversified
1.0
GBI EM Global Diversified
0.7
ELMI +
0.6
Datastream Global Gov’t Bonds
0.4
Barclays U.S. Treasuries
0.3
Barclays U.S. Corporates
0.9
Barclays U.S. High Yield with 2% issue cap
0.7
MSCI World
0.6
MSCI Emerging Markets
0.6
Source: JPMorgan, Barclays Capital, Datastream, ING Investment Management
11
Emerging Market Debt White Paper: November 2010
Accessing the Opportunities in a Growing Market Despite the unequivocal evidence of the growing importance of emerging economies, the outstanding corporate debt stock of emerging markets is equal to only around 1.3% of global outstanding debt. As the market continues to grow over the next ten years to a level more consistent with the contribution of emerging markets to the world economy, we expect this figure to approach 5.75%; this assumes that an average growth rate of 16% for the asset class based on historical primary issuance trends. The market’s expansion will likely draw greater attention to the asset class, and Figure 14 highlights the benefits that may be possible with only a small allocation to emerging corporates. By simply diverting 10% of a global fixed income portfolio’s assets from the Barclays Global Aggregate to an emerging corporates mandate, an investor historically would have picked up an additional 45 basis points of annualized return with slightly less volatility. The same 10% reallocation away from an all-U.S. bond portfolio would have generated a similar uptick in return, though with slightly more volatility. In addition, an increase in investor demand may result in a decline in volatility, further supporting the argument in favor of an allocation to emerging corporates.
Despite the potential of the asset class, corporate emerging market bonds are not widely available as a standalone investment.
Figure 14. A Small Allocation to Emerging Corporates Can Have a Big Impact December 31, 2001, through October 29, 2010 Annualized Return
Annualized Standard Deviation
Barclays Global Aggregate
7.45%
Barclays Global Aggregate
6.35%
Barclays U.S. Aggregate
5.74%
Barclays U.S. Aggregate
3.85%
CEMBI
8.45%
CEMBI
90% Global Ag/10% CEMBI
7.90%
90% Global Ag/10% CEMBI
6.26%
90% U.S. Ag/10% CEMBI
6.17%
90% U.S. Ag/10% CEMBI
4.14%
10.03%
Source: JPMorgan, Barclays Capital
Deciding to make an allocation to emerging market corporate debt based only on its historical performance, however, is complicated by the fact that the asset class is still in the development stage, and we only have limited history available. We believe the structure of the asset class will change to incorporate more non-investment grade bonds as these types of issuers gain better access to the market. At the same time, improving economic fundamentals in emerging markets suggest that many non-investment grade issuers have a good chance of graduating into better ratings, which should also generate positive return dynamics for early investors. Despite the potential of the asset class, corporate emerging market bonds are not widely available as a standalone investment; typically, investors who desire emerging corporate exposure are forced to invest in a broad emerging market debt product that consists mainly of sovereigns and tends to pay limited attention to managing corporate risk. JPMorgan estimates that as of September 2010, there were about $15 billion of CEMBI-benchmarked funds under management, with
Emerging Market Debt White Paper: November 2010
12
only $7–8 billion of it in CEMBI-only mandates and the rest in blended strategies. JPMorgan puts the number of investment managers in the emerging corporates space at about a dozen, compared with nearly 50 involved with emerging bonds in general.
For an investment manager to be successful in this space, research is critical.
13
However, select CEMBI-focused vehicles are beginning to appear — assets under management should reach $20 billion by the end of 2010 according to JPMorgan — affording investors both the option of an alternative asset in the credit spectrum and the ability to make a straightforward relative value assessment and allocation decision versus developed market investment grade and high yield corporate credits. For an investment manager to be successful in this space, research is critical. Though they have improved significantly in recent years, emerging markets are still far less mature than developed ones — meaning that corporate information may be more difficult to access, disclosure may vary in terms of quality and volume, and country/political/corporate governance factors play a significant role. A manager with a strong track record of investing in emerging market sovereigns and a deep understanding of the individual economic regimes would be at an advantage. Further, a manager with a strong local presence across multiple jurisdictions will be best positioned to develop the information advantages that lead to alpha generation.
Emerging Market Debt White Paper: November 2010
Conclusion Although still relatively underutilized, emerging market debt has been steadily growing in popularity in recent years as investors search for yield in a world of rock-bottom interest rates. However, emerging sovereigns may lose some of their high-yielding appeal as the underlying credit dynamics in developed and emerging nations continue to converge, forcing spreads to tighten. In such an environment, new — but similar — exposures like emerging market corporate debt could make up for the lost appeal of sovereigns. Emerging market corporates offer diversification benefits not unlike those of emerging market government bonds, but with a higher return potential and better credit quality. This is due both to the added yield corporates offer relative to sovereigns as well as the alpha potential inherent in such an under-researched/under-owned asset class. Given the growing importance of emerging markets to the global economy and the increasing stability of these countries, we think now is a good time for investors in all domiciles to consider allocating a portion of their diversified fixed income portfolios to the debt of emerging market corporations.
Emerging Market Debt White Paper: November 2010
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This review has been prepared by ING Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. The material presented is compiled from sources thought to be reliable, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. ©2010 ING Investments Distributor, LLC • 230 Park Avenue, New York, NY 10169
www.ingINVESTMENT.com
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