Published October 31, 2012
Investors have shown their affinity for both dollar-denominated emerging markets sovereign debt and those bond issued in local currencies this year. Inflows to ETFs ranging from the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSE: PCY) to the WisdomTree Emerging Markets Local Debt Fund (ELD) prove as much.
Whether or not that trade is getting crowded is up for debate, but as PIMCO notes "the supply of U.S. dollar-denominated EM sovereign debt is decreasing and yields are near historical lows." With those factors in mind, the world's largest bond manager is encouraging investors to evaluate the burgeoning market for corporate debt in the developing world.
In a note written by PIMCO's Ignacio Sosa and Anton Dombrovsky, PIMCO says "the dollar-denominated EM corporate market has been growing steadily, and many corporates can offer higher yields and lower durations than sovereigns."
It is accurate to say the size of the corporate bond market in the developing world has exponentially grown. ETF sponsor WisdomTree (WETF) said the emerging markets corporate bond market has doubled in size since 2008.
"Since 2003, EM U.S. dollar-denominated corporate bond issuance has outpaced sovereign issuance in a trend we believe will make EM corporate debt an increasingly larger allocation to emerging market fixed income," WisdomTree said in a note published earlier this year.
PIMCO offers its own take on the rise of developing world corporate debt, saying higher yields and short durations make the asset class attractive.
The proof is in the pudding regarding the higher yield and shorter durations claim. The $25.3 billion iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), the largest corporate bond ETF, has a 30-day SEC yield of 2.74 percent with an effective duration of 7.84 years. On the other hand, the WisdomTree Emerging Markets Corporate Bond Fund (EMCB) has a 30-day SEC yield of 3.69 percent and an effective duration of 6.23 years.
Bonds with lower durations are les sensitive to interest rate hikes. EMCB debuted in March, becoming the ETF focusing on emerging markets corporates to come to market. The fund now has $87.5 million in assets under management, making it one of the most successful new ETFs of 2012.
Does Size Matter A primary concern of many ETF investors is liquidity, particularly when it comes to emerging markets. To that end, the rapid growth of the emerging markets corporate debt arena could provide some level of comfort.
"The stock of EM corporate bonds outstanding has grown to around $1 trillion, dwarfing that of EM sovereigns at $680 billion," according to the PIMCO note. "Annual EM corporate issuance has increased dramatically from just over $20 billion in 2002 to about $200 billion on average since 2010."
Importantly, the growth of the emerging markets corporate debt market has not translated to increased risk. Nearly three-quarters of EMCB's are rated investment-grade. Issuers in the developing world are typically less leveraged than their U.S. counterparts. As such, default rates have been lower among emerging markets corporates over the past five years.
Scarcity Premium Sosa and Dombrovsky note that due to robust inflows to dollar-denominated emerging markets sovereign debt, supply has become limited. As a result, some portfolio managers have been forced to pay a "scarcity premium" that could make risk-adjusted yields "unattractive." In their note, Sosa and Dombrovsky said "EM corporates can also be used to replace EM sovereign bonds issued by countries that a portfolio manager no longer wants in the portfolio."
In theory, that could mean inflows to emerging markets corporate debt will rise in the future. The returns by select emerging markets corporates buoy the case for increased investment in the asset class. PIMCO points out that $1 invested in Russian corporate debt in 2008 would be worth more than $2 Wednesday. One dollar invested in Indonesian corporate debt in the same year would be more than $2.50 while the same dollar allocated to Chilean corporates in the same year has grown by 40 percent.
A similar trend is emerging at the ETF level. EMCB has already returned 6.6 percent since its debut and that fund pays a monthly dividend. Investors have also shown a modest appetite for risk with developing world corporates. The newly minted Market Vectors Emerging Markets High Yield Bond ETF (HYEM) debuted in May and has $21 million in AUM today. With a 30-day SEC yield of 6.63 percent, HYEM also pays a monthly dividend and has jumped more than fiver percent since its debut.
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