Published October 10, 2012
LONDON – New funds targeting debt issued by emerging market companies have helped push outstanding issuance past $1 trillion as investors chase high returns while sidestepping problems in developed economies.
Total volumes of debt issued by emerging companies are up tenfold since 2000 and the size of the market now rivals that for U.S. high-yield bonds. Investors are attracted by companies' strong balance sheets and rising demand for consumer goods and financial services in most emerging economies.
Emerging corporate debt has also milked a general rush from ultra-low-yielding developed markets, with new funds springing up to service demand.
Of 87 emerging market bond funds launched in the past nine months, 33 are dedicated corporate debt funds, according to Lipper, a Thomson Reuters company. Another 17 have said they will invest in both corporate and sovereign instruments.
Back in 2005, Lipper tracked just 10 corporate bond funds.
Full data is not yet available for this new cohort of funds, but preliminary numbers show that more than $1.5 billion flowed into these vehicles during the year to end-September.
"The market is visibly moving increasingly towards a corporate model," said David Spegel, global head of emerging markets strategy at ING. "More corporate-only managed mutual funds are inevitable."
Emerging sovereigns issued $72 billion in bonds in the first nine months of 2012, and look unlikely to approach 2009's record issuance of almost $100 billion, Spegel says. Corporate debt sales came to $227 billion in the same period, however, easily beating the $204 billion record set in 2009.
JP Morgan, whose emerging markets bond indices are widely used as a benchmark, says around half a trillion dollars tracks its CEMBI Broad corporate debt index, surpassing even the main EMBI Global sovereign index. Taking into account all corporate bonds, even those ineligible for the index, there is an outstanding $1 trillion in the asset class, a milestone passed last month, JP Morgan says.
Emerging corporate debt still struggles to shake off its reputation as a high-risk investment, plagued by default and murky governance. During the 2008 financial crisis, default rates in the sector rose to almost 14 percent, while a third of emerging companies defaulted on bonds in 2001-2002.
Fund managers argue the picture has improved. U.S. asset manager Alliance Bernstein, which recently set up its first dedicated EM corporate debt fund, says firms now have better leverage and cash-to-debt ratios than their U.S. peers.
That's reflected in credit ratings, with the CEMBI now carrying an average BBB rating, a notch above the sovereign index's BBB-, says Shamaila Khan who runs the new Alliance fund.
And yields are juicy, with the average CEMBI yield of 350 basis points over Treasuries providing a 60 basis-point premium over average emerging sovereign yields.
"On a valuation basis, you pick up spread when you go from EM country to EM company," Khan said.
Some reckon corporate debt may actually be safer these days than the sovereign equivalent, where falling yields have left investors with little premium to compensate for growing political risks or bad policies. Brazil and Mexico, for instance, pay less than 150 bps over U.S. Treasuries, while Russia and Turkey pay around 200 bps.
"Brazil is only one sovereign but you have the Brazilian steel sector, the beef sector, mining, banks - there is a lot more diversification and a lot more sectors. You play the Brazil story via the corporates," said Alia Yousuf, head of emerging debt at fund managers ACPI Partners.
Ratings continue to improve, too, with corporates receiving 44 net credit upgrades between July and September.
Investors can also increasingly hedge corporate debt against default. Data provider Markit last month launched credit default swap indices for Latin American and EMEA corporate debt.
"This would go some way to reducing the liquidity risk that has concerned investors, as EM corporate markets have grown rapidly," analysts at JP Morgan said in a recent note.
NOT WITHOUT RISK
Recents bets on the market have paid off handsomely: the CEMBI has returned more than 25 percent since January 2011.
Kazakh bank BTA defaulted this year for the second time in three years, however, a reminder that firms don't always repay debts and governments do not always come to their rescue.
ING predicts over $12 billion of defaults in 2012, more than double last year's total. And that may rise in future as debt raised during the current issuance bonanza falls due.
A big potential risk is the possible downgrade of Spanish and Italian corporate paper to junk in line with any such ratings cut for the sovereigns. That would force those companies to seek financing in speculative grade debt markets, which could crowd out emerging corporates, ING's Spegel warns.
But much recent EM bond issuance has reflected a switch away from the loans on which companies traditionally relied as hobbled banks cut lending, rather than a net rise in borrowing.
"We have not yet seen a situation where EM corporates are piling on debt, they are just substituting the financing market," said Alliance's Khan.
Not everyone is convinced, however. Cairn Capital - which manages over $7 billion - cites a lack of clarity over creditor rights for its decision to steer clear of the sector.
"An important part of the credit investment decision revolves around security, being comfortable about where you rank in the capital structure," said Cairn CIO Andrew Jackson.
"If I have no idea where I'm going to sit in the capital structure, it becomes a very tough - if not impossible - call."
(Additional reporting by Joel Dimmock and Ingrid Melander; Editing by Catherine Evans)