Emerging market (EM) credit offers exposure to higher growth countries and companies, diversification and the potential to deliver superior returns. In the latest Credit Spectrum, Andrey Kuznetsov, Senior Portfolio Manager at Hermes Investment Management, considers the nuances of the evolving EM credit market and the opportunities that ESG engagement with EM credit issuers can deliver.
From the shadows to the mainstream: the rise and rise of EM Credit
The EM credit asset class has undergone a rapid evolution from the 1970s when a wave of loans from multinational banks flooded in to fund EM governments’ infrastructure and development programmes.
The asset class currently stands at $2.5tn of issuance in hard currency alone – $1.5tn in corporate bonds and $1tn in sovereign bonds.The EM corporate credit universe is five times larger than European high yield and global convertible bonds and 25% bigger than the US high yield market. In the past decade, EM credit was the fastest growing fixed income asset class and it is now 8.5x larger than it was back in 2005.
With size comes a good degree of diversification and higher credit quality. For the most part, the EM credit asset class is rated investment grade (68% of the asset class) and with more than 700 issuers, the asset class provides greater diversification than the EM sovereign-bond universe (85 issuers). EM sovereign returns are driven mostly by geopolitical and macro factors.
While it is possible to analyse a country’s economic prospects, a change in the political landscape can impact this analysis meaningfully. In 2018 we saw a variety of political events driving returns in the market. Events such as presidential elections, IMF bailouts, US sanctions and geopolitical tension between the US and its trade partners added an extra layer of uncertainty. Similarly, in recent weeks, we have also seen heightened volatility in Turkey, where political uncertainty is helping to drive an economic crisis.
Window of investor opportunity
Corporate-issue EM bonds are also vulnerable to the macroeconomic environment, but the fundamentals of the issuer typically dictate long-term performance to a great extent. We often find that corporate fundamentals for EM companies are strong, and in many cases materially better than their developed market peers, due to ongoing focus on maintaining strong balance sheets and high levels of liquidity.
EM issuers have also been much more proactive in terms of dealing with short-term maturities than their developed-market peers, relieving some near-term pressures. Default rates for EM corporates are still low and expected to remain so, below that of developed-market high yield bonds, for the foreseeable future.
While it is clear that the EM asset class has plenty to offer investors who are looking for exposure to higher growth countries and companies, with the added benefit of portfolio diversification, we believe that where value can really be added is where investors can deploy smart engagement on environmental, social and governance (ESG) issues.
We see opportunities in Chinese Real Estate Debt
When carried out correctly, ESG integration is a dual-goal practice – a combination of risk management and alpha generation. In terms of risk management, given the rapid underlying-growth momentum supported by structural changes in the economies of emerging nations, one of the biggest risks for permanent loss of capital is ESG failures, such as governance issues.
China’s real estate companies have exhibited a period of high growth over the past decade, with rapidly growing enterprise valuations and increasingly larger, and often complex, capital structures. The cost of debt issuance is relatively high for many of the market leaders in the sector. Corporate issuers are seeking to minimise their cost of financing, from improving their financial ingenuity to broadening the geographical base of their investors.
Homebuilders play a crucial role in driving urbanisation and economic growth in China. New housing stock has improved standards of water sanitation and internet penetration. Urban town planning allows for closer proximity to workplaces and community amenities.
Furthermore, land sales to developers and property sales to homebuyers form a significant contribution to local government tax revenues.
We see substantial unaddressed ESG risks in the sector, associated with the rapid deployment of new urban properties across the Chinese republic, which offers the ability for engaged investors to add value and reduce credit risk. Specifically, we see engagement opportunities with companies on human capital management relating to the health and safety of construction workers, the quality and suitability of construction projects and issues relating to financing arrangements.
Today, EM credit is a large, diverse and highly-rated asset class, that warrants investors’ attention. While it may still lie in the shadows of other asset classes, the opportunity for asset allocators to diversify their portfolios, along with the potential for generating value through ESG engagement, makes this investment space increasingly attractive.