Many newcomers to the asset class, perhaps including Canadian pension plans, assume that emerging market corporate debt is too volatile, risky or niche, or that it has high defaults.
Yet, these are misconceptions, said Robert Nelson, vice-president, portfolio manager and research analyst of the EM debt team at Franklin Templeton Investments.
EM corporate debt is a growing and deepening asset class, he said, noting it possesses underappreciated quality and offers an attractive risk and return opportunity for investors. These attributes mean that it can now be considered a viable stand-alone asset class.
Since the global financial crisis, the asset class has grown from about US$400 billion to US$1.5 trillion, which is roughly the same size as U.S. high yield and European high yield combined. It is now too large to ignore, he said.
There has also been diversification by sector and by country, he added, highlighting that the market in China is growing drastically.
“Chinese companies are issuing dollar debt for a variety of reasons. You can think about the infrastructure spending, offshore,
‘one-belt, one-road’-type schemes,” Nelson said. “Chinese companies have also been issuing debt to repatriate funding back to China to make up for tighter liquidity conditions in China as well.”
No two emerging markets are the same and China is particularly unique, he added. “It really does need to be looked at very carefully. And in fact it requires investors, I think, to alter and update their investment processes.”
Tackling this area effectively requires on-the-ground expertise to sift through the noise and find opportunities, he noted.
As well, the idea that ESG is a non-starter in the emerging market corporate world is false, he added, highlighting that, in fact, the opposite is true.
ESG can be used as a negative screening tool and can also be a source of alpha by discussing governance and disclosure issues with companies’ management teams. “There’s a real opportunity to enhance disclosure, build confidence in a credit and, ultimately, tighten spreads and reduce the cost of capital, which is good for the issuer and the investor alike.”
Emerging market corporates are also surprisingly high quality, with an average
rating of BBB compared to the sovereign index at BB-plus, he said. “It’s a real mistake to think of EM corporates as being EM sovereigns, plus a load more risk at top. That’s simply not the case.”
Furthermore, historic default rates have been broadly similar to the developed market world. This is the case for the recoveries world as well. “When it comes to recoveries . . . bond covenants tend to be stronger in the emerging world than the developed world; which, again, surprises some people.”
There are also lots of examples of corporates that are able to differentiate themselves from the countries in which they operate, he added.
When it comes to the return potential of the asset class, there is evidence suggesting that investors are better compensated for underlying quality and volatility than in the developed world, he said, noting that, in addition to higher yields, a lower duration also adds the allure.
Overall, there’s a strong case for emerging market corporate debt. “It has underappreciated quality, both from a ratings point of view and a fundamental point of view. And there’s a pretty clear risk-return argument as well.”