Following vast improvements in issuance, liquidity and credit quality, we expect that corporate debt will become the dominant emerging market hard currency asset class in terms of appetite and portfolio allocations within the next five years.
Volume and high quality
Emerging market corporate debt now exhibits much higher quality than many may realise. For example, the emerging market corporate universe is comprised of more than 70% investment grade issues.
The index for this high quality asset class (JPM CEMBI Diversified) has a higher average rating than the emerging market sovereign index (JPM EMBIG). The high quality will be further reinforced as more than 80% of new issuance is rated investment grade in 2012 thus far.
High credit quality is supported by the strong balance sheets of these emerging market companies. Since current global growth is mainly driven by emerging market countries, many emerging market corporates also enjoy strong organic growth which further strengthens their balance sheets and keeps average leverage low despite increased issuance.
In terms of assets, in August this year the market capitalisation of the emerging market corporate debt index surpassed that of sovereign debt for the first time. Furthermore, corporate debt issuance is likely to represent over 70% of total emerging market external debt issuance this year, with a forecast to reach $310bn issuance in 2012 versus $86bn for emerging market sovereigns.
We expect the growth in emerging market corporate debt to continue – driven by high levels of issuance – and that this market segment could exceed the size of the US high yield market in the near future.
Despite this growing prominence, corporate debt currently remains an under-owned asset class within investors’ portfolios. However, the coming of age in the market, as well as increasing recognition for the quality of the asset class, means that emerging market corporate debt will likely exceed sovereign debt within investors’ portfolios within five years.
Specific opportunities
We believe the best risk-adjusted returns will be found among a growing segment of emerging market companies, particularly those in Latin America and central and Eastern Europe. The investor demand for these companies to issue in the external market has increased as sovereigns are issuing less and less in the external debt market.
Many investors are starting to take note of the positive trends in emerging market corporate credit and we believe it is also poised to potentially exceed sovereign debt in investors’ emerging market allocations in the next five years.
The increased investor interest combined with a growing number of dedicated emerging market corporate debt investment funds available is a sign that investors are increasingly considering it on its own merits, as opposed to a marginal allocation within their global EMD or global credit portfolios.
Despite these positive trends for emerging market corporates, some challenges remain, driven by market dynamics as well as investor perception. In addition, liquidity can be an issue, particularly during times of an overall market downturn.
Although these challenges may create volatility in the short term, we believe that current valuations and future convergence with emerging market sovereign debt make now an attractive entry point into the asset class for investors with medium and long-term investment horizons.
