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July 22, 2021 | GSAM Connect

Emerging Markets Corporate Debt: Strong and Getting Stronger?

Jasper Sagoo, client portfolio manager on the Emerging Markets Debt team within Goldman Sachs Asset Management, shares his team’s observations on the performance of Emerging Markets Corporate Debt and explains why we believe there is no substitute for thorough, structured credit research to unlock the return potential of the asset class.

Q: Jasper, looking back at 2020 and the first half of 2021 - what stood out for you in terms of performance of Emerging Markets Corporate Debt (EMC)?

We made two interesting observations. Firstly, the draw-down in EMC in 2020 was over 25% less compared to sovereign debt, while also delivering meaningfully less volatility. Secondly, the default rate for High Yield EMC issuers, which account for approximately 40% of the EMC investment universe, was 3.5% - a stark contrast to US High Yield at 7%.[1]

During the first half of 2021, EMC continued to deliver a more stable stream of investment performance, particularly during the US-rate-induced market volatility during the first quarter, with total returns benefitting from over three years less duration exposure than sovereign debt[2].

Q: How do you see the remainder of 2021 unfolding?

Following the worst phases of the COVID shock, the deterioration in fundamentals as measured through net leverage, the measure of a company's financial leverage, was less than experienced during the oil crisis in 2015, and in part due to strong company management. Net leverage is expected to improve through 2021 as company earnings recover.

From a valuation perspective, there is an attractive relative value case versus comparable fixed income credit alternatives, as EMC spreads have lagged the significant recovery seen in DM credit thus far, particularly when looking at US and European, High Yield and Investment Grade corporates. EMC investors can earn over twice the spread per turn of leverage than US High Yield offers. Whilst sovereign Emerging Markets Debt screens as cheaper relative to its historical trading range, the fundamental outlook for Emerging Markets companies appears more stable and less uncertain compared to many sovereign countries across the world. The EMC asset class has continued to offer a source of yield and income in what is ultimately still a low-yield world, and importantly spread valuations screen as attractive relative to Developed Markets credit opportunities.

We expect modest issuance as companies are acting conservatively, and in the face of improved cash flows they continue to limit shareholder-friendly activities such as capex, M&A or paying sizable dividends, that are typically financed through debt.

At a company level, we find non-cyclical companies including bottlers, telecoms and telecom towers, have emerged strongly through the COVID shock, due to implementing cost efficiencies and benefitting from product resiliency. Cyclical sectors including gaming and property, as well as transport were impacted more significantly, but have handled liquidity and refinancing proactively, and continue to do so whilst waiting for a return to normalcy in travel and consumer behaviour.

Q: In your view, what types of investors would potentially benefit from an allocation to EMC?

The case for the asset class has not gone unnoticed and we have observed a steady trend of investment and interest across a broad array of investor types including:

  1. Investors seeking to enhance Developed Markets credit portfolios, also referred to as cross-over investors,
  2. Sovereign Emerging Markets Debt investors seeking to enhance diversification, credit quality, and enhance alpha potential,
  3. Insurance investors seeking to optimise return on capital.

Against a backdrop where net financing needs, particularly outside of Asia, are expected to be relatively modest we believe growing strategic demand for the asset class suggests a supportive technical picture.

However, for all their merits, Emerging Markets companies are still exposed to exogenous risks, for example, emanating from the risk of sovereign downgrades (e.g. Colombia, India), or political uncertainty (Peru, Turkey) and geopolitical uncertainty (e.g. Russia, Ukraine), and broader macro conditions such as risk sentiment, financial conditions and commodity prices. Investors need to diligently consider these factors during the research process to uncover attractively valued companies with mitigating characteristics that afford them with a high degree of resilience.

Q: How do you identify investment opportunities within EMC?

We believe there is no substitute for thorough, structured credit research to identify inefficiencies and mispricings and to unlock the return potential of the asset class, which is why we build our portfolios company by company. Diversification is critical within emerging markets to insulate investors from the unexpected, and part of the risk premia investors earn in the asset class stems from a higher likelihood of the unexpected occurring across the 800 companies within the investment universe.

We aim to truly understand the companies we are considering to invest in: their offerings, their competitive positioning, industry dynamics, outlook and quality of management, and we always meet with the companies we invest in.

To understand the bigger picture, we also partner with our own Emerging Markets sovereign economists to understand the macro backdrop a company is operating within. We want to know whether companies are aligned with the broader sovereign strategy and policy objectives for each country, i.e. de-carbonisation, energy security, or social objectives.

ESG analysis is deeply integrated within the fabric of our investment culture and our analysts diligently assign internal ESG scores for issuers under their coverage, utilising a materiality-based approach that focuses on the most important factors for each industry. In the ESG evaluation of issuers, our analysts determine a forward-looking momentum view, informed by our engagement with companies.

Q: Is there a ‘sweet spot’ within EMC that can potentially generate yield for investors?

Yes, at present we believe the sweet spot is within select BB issuers where investors can potentially earn healthy yields, whilst avoiding overly exposing a portfolio to vulnerabilities present in lower rated credits. This is consistent with our strategy to access resilient income. We have a structural preference through time for non-cyclical issuers, and place emphasis on issuers that we find to have resilient qualities.

 

[1] JP Morgan as of March 31, 2021.

[2] Goldman Sachs Asset Management as of May 31, 2021.

 

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About the Author

Jasper Sagoo

Jasper Sagoo

Emerging Markets Fixed Income Client Portfolio Manager, Goldman Sachs Asset Management

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