Emerging-market corporate debt has risen in popularity this year, attracting yield-seeking investors. However, a selective approach to this market is required as many of its advantages have been priced in and risks remain. Here we discuss two emerging-market investments in our funds whose fundamentals should support performance beyond the rally.
Pivot to emerging markets
Global high-yield credit managers have enjoyed a significant boost from their allocations to regions outside the US and Europe this year. Emerging-market corporate bonds have undergone a remarkably quick transformation from one of the least-loved asset classes to one of the most popular. This shift has been driven by a range of factors.
First, with close to half of developed markets yielding less than 1%, emerging-market debt is comparatively attractive, particularly as other asset classes are also struggling to offer yield. Second, the stabilisation of many commodity markets has offered relief for the numerous emerging-market economies that rely on commodity exports. Finally, a weaker dollar and lower-for-longer interest rates have fuelled a tentative recovery in emerging-market currencies.
The increasing attractiveness of emerging markets has prompted a stream of inflows into emerging-market hard-currency funds, pushing year-to-date cumulative flows to $12bn, or 9% of the funds’ current assets under management. Issuance has picked up recently but remains at its lowest level in four years, providing a supportive supply-demand dynamic.
Severstal and Gerdau
We have exercised our mandate to find credit opportunities worldwide by buying emerging-market debt, targeting issuers that have global scope, strong fundamentals and underappreciated recovery stories – such as the Russian and Brazilian steel companies Severstal and Gerdau.
Severstal has a strong asset base with relatively low costs, due partly to its proximity to export infrastructure and a conservative financial policy. As a result, even in the ongoing volatile market for global steel and amid Russia’s recession, the business has significantly improved its credit profile, leading to its recent upgrade to investment grade by S&P. Having paid down its 2016 maturity bonds, Severstal now has three outstanding bonds maturing in 2017, 2018 and 2022. We invested in the 5.9% 2022 bonds issued in 2012, as we believed they provided the most attractive exposure to the company’s improving credit story.
Severstal has improved its credit profile in the past two years
Source: Hermes Credit, Severstal as at August 2016
Gerdau is a globally diversified business with a strong market position in its largest market, Brazil. Its assets are mainly mini-mills rather than large integrated steel mills. The company has historically been financially prudent, raising equity, buying back bonds and refraining from issuing debt over the last two years. Within its capital structure, we prefer the 5.893% 2024 note, which offers greater convexity and spread pick-up than the 4.75% 2023 notes.
Valuations in emerging markets have now largely normalised. With oil prices experiencing a renewed decline and other commodities falling in value, combined with the prospect of an increase in US interest rates and ongoing geopolitical concerns, emerging markets face a range of risks. This makes it essential to thoroughly assess operating, financial and ESG risks to identify companies that are able to prosper in an environment where many emerging-market economies are still struggling to grow.
Emerging-market corporate debt valuations, Nov 2013 to Jul 2016
Source: Hermes Credit, Bloomberg as at August 2016
We are therefore selectively investing in higher quality instruments as the easy wins of the resurgence of emerging-market performance have been taken. That said, given the persistent shortage of yield globally and the effects of renewed quantitative easing by the Bank of England and European Central Bank, it is more important than ever to fully exploit our flexible, global mandate to generate strong returns with appropriate risk.
Past performance is not a reliable indicator of future results and targets are not guaranteed. This article does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
Breaking with (un)convention