The impressive growth of credit markets beyond the US presents compelling opportunities for investors seeking greater diversification. In his latest report, Andrey Kuznetsov, Portfolio Manager at Hermes Investment Management, explores the factors that have helped spur this growth and the potential for generating alpha through active engagement on environmental, social and governance (ESG) issues.
The great European bond boom
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, 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, with the number of issuers coming to the high yield market doubling in the last decade1.
Holding European credit can add diversification to US credit-heavy portfolios due to the starkly different sector composition. It can also help 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.
Turning their backs on the greenback
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.
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 market2. This has been driven by several factors:
• Reverse Yankees allow companies to manage risks arising from increased currency volatility by matching revenues and costs
• They widen the investor base, enabling companies to raise debt at a lower mixed cost
• They facilitate any future acquisitions in European markets by raising a company’s profile and awareness among investors
Credit where it’s due: optimising the risk-return profile
Looking further afield, adding emerging markets to a credit portfolio could help 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 underpin 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. 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.
Our engagement experience with Pemex, which relies heavily on the international debt markets, is a good illustration of this. 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. We subsequently engaged with the company on its commitment to a zero-tolerance campaign regarding workplace accidents, as well as its target of a 25% reduction in carbon emissions by 2021, while scrutinizing 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.
A global, diversified approach is key
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.
- 1 Source: ICE Data Indices LLC, Hermes Credit as at August 2018
- 2 Source: ICE Data Indices LLC, Hermes Credit as at August 2018