In this issue of Spectrum we discuss the impressive growth of credit markets beyond the US and the compelling opportunities this presents for investors seeking greater diversification. We also explore the potential for generating alpha through active engagement on environmental, social and governance (ESG) issues.
The eurozone crisis and Brexit have dominated headlines in recent years, but – behind the scenes – something of a mini-economic miracle has been taking place in the European credit markets: the rise of the European corporate bond.
Before the launch of the euro in 1999, Europe’s corporate lending market was dominated by local banks operating at individual country level. However, in recent years, the powerful combination of the single currency’s growth, regulatory change and the development of a liquid corporate bond market has led to a boom in companies using the bond markets as a means of raising debt; the number of issuers coming to the high yield market has more than doubled in the last decade, from 139 in August 2008 to 283 as of August 20181.
This reflects the compelling case that has been made for adding European credit to portfolios that have been historically US credit heavy. For a start, the starkly different sector composition of the European markets offers excellent diversification: energy, for example, comprises 16% of US high yield credit (versus just 3% in Europe)2.
Holding European credit also helps to reduce risk by diversifying exposure to economies at different stages of the credit cycle. Additionally, the European high yield market currently offers similar spreads for higher average credit quality. Overall, from the point of view of the efficient frontier, adding European high yield to US high yield can improve the risk-adjusted return profile of the portfolio.
It’s not only the credit markets outside the US which are booming. Issuance of bonds in non-US dollar currencies has also ballooned; the non-US dollar portion of the global credit market has surged from less than 5% in early 2000s to almost 25% of the market in 2018 (see figure 1). This trend is partly due to the increasing number of companies that have local operations in many countries. Company CFOs therefore have the flexibility to issue debt in currencies other than that of their country of domicile.
Figure 1: The composition of the developed market high yield (by currency) has changed dramatically
Source: ICE Data Indices LLC, Hermes Credit as at July-2018.
Over the past few years, corporate America has rediscovered the attractions of the Reverse Yankee market – essentially debt issued in Europe by American companies – which currently stands at €37bn, which is nearly 16% of the European high yield market3. This has been driven by several factors:
This strategy has proved so popular that US companies are now the second largest issuers of euro-denominated debt after France (see figure 2). As the credit cycle matures, investors must consider carefully which instruments within their capital structure will ensure the best risk-adjusted returns. As we discuss in the example below, Reverse Yankee bonds can be the most attractive instrument within the capital structure of a US-based company.
Figure 2: US companies are the second largest issuers of euro-denominated high yield debt
Source: ICE Data Indices LLC, Hermes Credit as at July 2018.
US-based clothing company Levi Strauss is famous as the inventor of blue jeans during the San Francisco Goldrush of the 1870s. Since then Levi’s Jeans has become one of the world’s most iconic brands. Its reputation and profile has underpinned its credit performance over the years as robustly as the brass rivets on its famous denims. It is a truly global brand: in H1 2018, the company’s operations were 51% in the Americas, 32% in Europe and 17% in Asia, providing a diversified exposure to the global consumer. With bricks-and-mortar retailers with poor online strategies undergoing a period of enormous upheaval, Levi Strauss is well positioned to emerge as one of the winners. The company has a good balance between exposure to wholesale distribution (Amazon, Macys, etc.) and direct-to-consumer retailing (nearly 3,000 of its own physical stores and online e-commerce activities).
The company’s capital structure is well-adapted to the tough current market environment, while the management’s policy on shareholder dividends is conservative compared to its peers. Within that capital structure, the Reverse Yankee 2027 bond stands out as the most attractive instrument. Compared to the five-year credit default swap (CDS) quoted at 115bps4, the LEVI 3.375% 2027 bond offers an additional 160bps in option-adjusted spread, or 40bps per year, which is attractive for credit of this quality. Compared to the US dollar bond, the Reverse Yankee bonds offers 100bps pickup for less than two years.
Figure 3: The Reverse Yankee 2027 bond is the most attractive instrument in Levi Strauss’ capital structure
Source: Hermes Credit as at August 2018.
Looking beyond the US to euro-denominated debt is, however, only one strand of a far bigger opportunity in the credit markets. This arises from the huge disparity between the burgeoning size of the emerging market economies and the relatively small scale of their financial markets.
The shift in economic power to the emerging markets is well-documented. The developed world now accounts for less than 15% of the global population while emerging economies are playing a bigger and bigger role in global markets. As a group, those economies now comprise almost 60% of global GDP and account for more than 80% of global growth since the 2008 financial crisis5. According to IMF forecasts, emerging markets and developing economies are expected to grow at around double the rate of the advanced economies from April of this year6. Moreover, with growth likely to accelerate, they could potentially outperform the developed world by a factor of three beyond 2019.
Figure 4: Emerging markets and developing economies are expected to grow by double the rate of advanced economies
Source: International Monetary Fund as at April 2018.
At the same time, these developing economies account for a much smaller piece of the entire global financial market. For example, capitalisation of the emerging markets equity market is only 13% of the global equity market7 – and the number is similar for the credit market. As global credit investors, we are aware of the spectacular growth that emerging markets have achieved over the past 10-15 years, and constitute one of the fastest growing asset classes over the period. This rate of growth will continue, driven by several underlying trends:
Figure 5: Growing fast with room to accelerate
Source: Barclays Research as at August 2017.
Adding emerging markets to the credit portfolio helps to improve overall risk-adjusted returns for investors. A globally diversified credit portfolio has multiple benefits: it provides exposure to various, distinct macro-economic environments that are underpinned by particular characteristics such as a rapidly growing middle class (as is the case in China, for example). Moreover, as well as giving a greater choice of available credits with different sectoral compositions, emerging markets credit offers attractive returns for leverage. Engaging with emerging-market companies should help them to improve their ESG metrics and close the gap with their developed market peers, thus creating value for asset owners in the process.
Figure 6: The globalisation of credit market is making geographical diversification more important
Source: BAML as at August 2018.
Active engagement with emerging markets credit issuers is encouraging them to improve their sustainability policies. As investors increasingly apply global benchmarks across all asset classes, a substantial number of emerging market companies are looking to close the gap in ESG profiles with developed market peers.
Last year, our research paper Pricing ESG risk in credit markets analysed the relationship between ESG risks and credit spreads. It found clear evidence of a good corporate citizen dividend: companies with poor ESG practices tend to have wider and more volatile spreads, while the reverse is true for firms with good ESG characteristics8.
While our research identified a correlation between credit quality and our proprietary measure of ESG – the Quantitative ESG (QESG) Score – this is not enough, on its own, to accurately determine ESG risk. A more precise measure is achieved by plotting spreads against QESG scores. This works in two ways: it helps us identify opportunities in lower-rated companies with higher ESG scores; and it highlights those companies at risk because their spreads are too tight relative to their QESG scores. We use this model alongside the ones to price the core credit risks – operating and financial.
Figure 7: ESG metrics correlated with cost of capital
Source: Hermes as at August 2018. For illustrative purposes only.
Developing markets are fertile ground for generating additional alpha by fostering improvement in ESG metrics. Our global approach to credit markets provides a strong foundation for engagement with emerging market companies and we work with them on the ESG factors that are deemed most important to their particular credit class. Our experience of engaging in these markets has been positive, with companies increasingly realising that a growing number of credit investors incorporate ESG into their investment process.
Figure 8: Increasing acknowledgement of the importance of ESG integration
Source: UNPRI as at August 2018.
Our experience with oil company Pemex is a good illustration of our commitment to fostering best practice in ESG through active engagement. In our commentary Fuelling change at Pemex: Why ESG analysis matters in credit decisions, we highlighted that, despite being wholly-owned by the Mexican state, the company relies heavily on international debt markets to fund its operations, with about $82bn9 of debt outstanding10.
We originally characterised Pemex’s ESG risks as higher than average due to its poor track record in labour safety and its history of frequent oil spills and leaks. However, we subsequently initiated engagement with the company and met its sustainability and investor relations teams.
Figure 9: Engagement is a crucial element of ESG integration
Source: Hermes as at August 2018.
As our team developed a relationship with Pemex, we discussed its commitment to a zero-tolerance campaign regarding workplace accidents, as well as its target of a 25% reduction in carbon emissions by 2021. More importantly, we scrutinised the initiatives it had put in place to achieve those goals. Having monitored progress over time, we saw an improvement in workplace safety along with measurable reductions in environmental waste and emissions. These findings persuaded us that the company was genuinely trying to improve its ESG profile.
The current strength of the dollar and the much-publicised currency volatility in several emerging markets, such as Turkey and Argentina, have obscured a strong underlying trend towards the globalisation of the credit market and the potential this offers for improving portfolio risk and returns.
Today, holding euro-denominated corporate bonds is becoming an essential element of any global credit portfolio, while currency selection remains a key aspect of any successful investment strategy, as evidenced by unique opportunities presented by the Reverse Yankee bonds in securing superior risk-adjusted returns for credit investors.
Going forward, emerging markets are key given the compelling opportunities they offer – and active engagement with emerging market companies on ESG considerations is an important means of delivering a better financial return and a public good.