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    GSAM Insights

    NAVIGATING THE EM CORPORATE BOND MARKET

    Navigating Fixed Income

     

    November 2022  |  12 Minute Read

    Nick Saunders

    Head of the Emerging Market Corporate Debt Team

    Nick Saunders

    Ben Trombley

    Emerging Market Debt Portfolio Manager

    Ben Trombley

    A striking shift in sentiment combined with macro headwinds has weighed on emerging market (EM) assets in 2022, including the EM corporate bond market. This month we highlight five reasons why we believe investors should maintain—or add—a structural allocation to EM corporate bonds as a complement to existing developed market (DM) corporate or EM sovereign bond exposures. In short, we believe EM corporate bonds are a high-quality source of yield that can offer diversification benefits. But there is no one-size-fits-all formula for investing in EM corporates and we believe the breadth of the market requires top-down macro insights and active bottom-up security selection.

     

    The EM Corporate Bond Market is a Large and Diverse Opportunity Set Yet Remains Underinvested

    In 2017 when the EM corporate bond market crossed the $2 trillion mark, we argued the asset class deserved a structural allocation in investor portfolios as a complement to existing DM corporate credit or EM sovereign bond exposures. In 2021, the market experienced its fastest growth since 2009, expanding to $2.7 trillion, further cementing its status as a mainstream sector in the global fixed income opportunity set. It is now almost twice the size of the US high yield (HY) and EM sovereign external bond markets, and more than four times larger than the European HY market (Exhibit 1).

     

     

    Exhibit 1: EM Corporate Bonds Are a Mainstream Asset Class

     

    Source: J.P.Morgan. As of 2021.

     

    The diverse EM corporate universe can meet varying investor appetites along rating, duration, or regional dimensions. It contains everything from quasi-sovereign utilities to Telecommunications giants and search engines to electric vehicle (EV) manufacturers. From a portfolio construction perspective, the breadth of the sector leads to low performance correlation with other asset classes, underscoring its role as a source of diversification for existing EM sovereign bond or DM corporate bond allocations.

     

    More broadly, the EM corporate bond market can provide exposure to economic growth as well as secular themes. Many companies in the investment universe are helping to advance long-term goals including supply chain security, digitisation, and decarbonisation as well as traditional growth areas such as serving the consumption needs of a rising middle class and infrastructure development. As an indication of EM company focus on environmental objectives, new issuance has shifted towards green bonds in 2022, where proceeds are used to finance climate- or environment-related projects, assets, or activities. In 2015, green bonds accounted for just 1% of new bond issuance. In 2022, that share has increased to 18%.1

     

    Did you know? Urbanisation of China’s rural cohort (which represent 56% of the total population and 63% of the workforce) and its experience-seeking Gen Z consumers (who account for 18% of the population) presents significant revenue potential for corporates in EM Asia.2 Surveys suggest local brands can gain market share through strong market awareness, better affordability, and entrenched local sales channels.

     

    Case Study: Adding EM Corporates to an Existing DM Corporate Bond Allocation

    We seek to partner with our clients to understand their investment goals and convert investment insights into compelling investment solutions. The number of tickers in the US investment grade (IG) market rose from 811 in 2015 to 1006 in October 20223. Meanwhile, the ticker count in the EM corporate bond market experienced larger growth, rising from 1,217 in 2015 to 1,777 over the same period4. In our view, this suggests that institutional investors in corporate bond markets should consider EM corporates as way to diversify existing DM corporate bond holdings. Indeed, we have partnered with US insurance clients to expand their corporate bond allocations to include EM corporate bonds.

     

    Healthy EM Corporate Fundamentals Helps to Build Resilience to Macro Headwinds

    EM corporate credit metrics appear well positioned for macro headwinds such as slower growth, continued inflation, and policy tightening (Box 1). For example, net leverage is at its strongest (i.e., lowest) level in a decade (Exhibit 2). More broadly, EM corporates tend to be less financially levered relative to equivalent rated companies in the US and Western European corporate bond markets.

     

    Did you know? The EM corporate bond market is skewed towards IG bonds, with an average index rating of BBB5. Companies typically place greater emphasis on preserving or improving credit ratings relative to DM peers, with HY companies often aspiring to achieve IG ratings. This IG rating skew challenges a widely held view that EM corporates are only an alternative to US HY bonds. It also calls into question the conventional wisdom that EM assets only have potential to deliver higher returns relative to DM counterparts, albeit with higher volatility, because they entail higher risk or lower credit quality. Rather, we think the higher return potential in EM corporate bonds reflects factors such as lower liquidity as well as underappreciated risks and opportunities due to the investment universe being less well-researched compared to other corporate bond markets.

     

     

    Exhibit 2: EM Corporate Net Leverage is Stable or Improving and Typically Tracks Below DM Peers

     

    Source: J.P.Morgan. As of September 2022.

     

    Box 1: EM Corporates Tend to Display Resilience to Macro Headwinds

    There is no shortage of things on the wall of worry for EM assets in 2022 given the war in Ukraine, higher sovereign debt levels following the pandemic shock, deleveraging in China’s property sector and a cost-of-living crisis. The selloff in 2022 also features familiar concerns around rising funding costs for EM borrowers with dollar-denominated debt. We address the trio of key headwinds—rising US rates, a stronger US dollar and weaker growth—below.

     

    Headwind 1: Rising US Rates

    Historical returns demonstrate that rising US interest rates are not synonymous with EM corporate bond underperformance (Exhibit 3). We believe several factors will uphold a similar trend in the current cycle. First, EM companies with dollar-denominated debt are typically located in higher-rated EM economies and have access to alternative sources of funding, including onshore borrowing. Second, near-term refinancing risk is moderate given companies have tapped bond markets over the past decade and pushed out maturities. The debt that does mature over the coming years seems manageable given the composition is tilted towards segments of the market with broader alternative refinancing sources, such as investment grade-rated companies. Finally, relative to their sovereigns, EM companies have greater flexibility to cut spending and passthrough the impact of higher costs to end consumers to preserve credit metrics.

     

     

    Exhibit 3: Historically, EM Corporate Returns Are Relatively Resilient as US Interest Rates Rise

     

    Source: J.P.Morgan. EM corporates is based on the J.P. Morgan CEMBI Broad Diversified index. As of September 2022. Shaded rows reflect periods when US Treasury yields are rising. Past performance does not guarantee future results, which may vary.

     

     

    Headwind 2: A Stronger US Dollar

    We think the impact of a stronger dollar is limited for two key reasons. First, 54% of external currency EM corporate bonds are from issuers located in countries with managed or pegged currencies, meaning they are less exposed to US dollar strength6. A further 9% of bonds are from companies in countries with healthy current account surpluses and foreign currency reserve buffers that can be used to manage the impact of a stronger dollar. Second, many management teams have developed risk management experience from prior currency crises and therefore have implemented financial hedges. In addition, some businesses have a natural hedge to currency volatility through dollar-denominated revenue streams—this holds particularly true for companies in commodity-oriented sectors.

     

    Headwind 3: Weaker Growth

    Many companies have strong competitive positions, stable business models, and possess pricing power, all of which can create built-in resilience to a weaker growth environment. In addition, a large share of the market is represented by quasi-sovereigns, meaning issuers benefit from implicit or explicit government support.

     

    What are quasi-sovereigns? A quasi-sovereign is a company with full or partial government ownership or control, a special charter, or a public policy mandate from the national, regional, or local government7.

     

    Quasi-sovereign bonds account for 44% of the corporate bond market,8 with a higher share in sectors that fulfil government policy objectives such as oil & gas, infrastructure, and financials. Examples include oil & gas producers such as Petrobras in Brazil and Aramco in Saudi Arabia, fertilizer producer OCP in Morocco, and infrastructure companies like Aeropuerto Internacional de Tocumen in Panama and DP World in Dubai. Government involvement can help issuers navigate cyclical challenges and sustain long-term investments that may boost innovation and economic growth. That said, a risk among these issuers is uncertainty around a government’s ability to provide support in the event of sovereign-level challenges.9 More broadly, EM corporates are accustomed to macro volatility including elevated inflation, growth weakness and currency devaluations.

    Valuations Are Attractive Relative to Healthy Fundamentals

    The rating composition of the EM corporate bond is roughly equally split between IG and HY. Compared to an equivalently rated DM portfolio, the EM corporate bond market offers a consistent spread premium (Exhibit 4). Further, spread per turn of leverage is higher than the US corporate bond market. In other words, the EM corporate bond market offers higher spreads despite healthier fundamentals.

     

    We believe current spreads appear attractive considering the peak in downgrades and defaults for the current cycle is likely behind us (Box 2). In our view, this suggests further weakness may be an opportunity to add exposure in issuers with robust fundamentals.

     

     

    Exhibit 4: EM Corporate Bonds Offer a Spread Premium Over Comparably Rated DM Peers

     

    Source: J.P.Morgan, Bloomberg, Goldman Sachs Asset Management. Spread premium = EM corporate spread – US corporate portfolio (50% IG, 50% HY) spread. As of October 31, 2022. Past performance does not guarantee future results, which may vary. For illustrative purposes only.

     

     

    Box 2: Weakness in 2022 Has Been Idiosyncratic, Not Broad-Based

    The EM corporate index is down ~-20% year-to-date (YTD)10 but weakness is largely driven by Russia—where corporates have underperformed amid economic sanctions in response to the war in Ukraine—and China’s hard-hit property sector. A similar concentration of weakness is observed in the Asia HY market, a subset of the EM corporate bond market. Excluding Russian corporates, which departed the EM corporate index in March, YTD performance is better than US IG credit and closer to US HY credit (Exhibit 5). The impact of China’s property sector has been felt most in the HY segment of the EM corporate universe. By contrast, commodity-oriented corporates have held up well, supported by firmer oil prices.

     

     

    Exhibit 5: Excluding Russia, YTD Returns Are Better Than US IG and Closer to the US HY Market

     

    Source: J.P.Morgan. As of October 2022. Past performance does not guarantee future results, which may vary.

    Where are the opportunities? We see value in recession-resistant non-cyclical sectors such as Food & Beverages where companies benefit from strong brand recognition and customer loyalty. Our exposures range from a Chilean beer brand with presence across Latin America to a Turkish Coca-Cola bottler that operates in markets in the Middle East and Asia. We are also overweight domestically-oriented Banks—operating in countries such as Mexico, Colombia, and Israel—that have traditional lending models, strong capital positions and strong net interest margins. Lastly, across Latin America, we see investment potential in bonds issued by Airports. Structurally, we find opportunities in companies which are aligned to secular themes like the energy transition, such as Indian Renewables.11

     

    The EM Corporate Bond Market Has a Strong Track Record

    Notwithstanding recent idiosyncratic weakness, EM corporate bonds have delivered solid total returns since the global financial crisis, particularly in comparison to comparable rated DM corporate bond markets and the EM sovereign market on a volatility-adjusted basis.

     

    More specifically, the EM corporate bond market exhibits a similar volatility-adjusted return profile as a DM corporate bond portfolio that is split equally between IG and HY bonds (Exhibit 6). Put another way, the EM corporate bond market provides investors with higher yields—currently around 8.5%12—for similar credit quality and firmer fundamentals. We believe these features of the market highlight why EM corporate bonds can offer value as a structural complement to existing DM corporate or EM sovereign bond exposures.

     

     

    Exhibit 6: EM corporate bonds have a similar volatility-adjusted return profile as similar rated DM peers

     

    Source: J.P. Morgan, Bloomberg, Bank of America, Goldman Sachs Asset Management. DM 50% IG / 50% HY is an equal weighted portfolio of a US 50% IG / 50% HY and European 50% IG / 50% HY. Based on last 14 years data between October 2008 - October 2022. Past performance does not guarantee future results, which may vary. For illustrative purposes only.

     

     

    From a credit event perspective, historical default activity as well as recovery rates for EM HY corporates is comparable to US HY corporates. In fact, in 2020, the default rate for EM HY corporates was 3.5% versus a 6.8% rate for the US HY corporate bond market13. Further, EM corporate default rates tend to be lower than DM peers, while recovery rates are broadly similar (Exhibit 7).

     

     

    Exhibit 7: EM Corporates Tend to Default Less Than DM Peers and Have Similar Recovery Rates

     

    Source: S&P Global Ratings Research and S&P Global Market Intelligence’s CreditPro, JP Morgan EM corporate.
    Source: J.P.Morgan. As of June 2022. 2022 recoveries exclude Russia. Average of annual recovery rates where available since 2000. Past performance does not guarantee future results, which may vary.

     

     

    The Near-Term Technical Backdrop is Balanced

    Market volatility amid rising interest rates has led to subdued new supply in 2022. This has helped to balance the impact of weaker investment demand. Estimates point to gross issuance of $260bn this year, the lowest annual supply since 2015, and negative net issuance of $218bn, implying the first shrinking of the asset class in two decades. Overall, we consider the technical—demand and supply—backdrop to be broadly balanced.

     

     

     

     

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    1 Source: J.P.Morgan, BondRadar. As of September 2022.

    2 Source: Goldman Sachs Global Investment Research. Data as of 2019 Source: NBS, Xinhua, CEIC. Gen Z represents the younger generation born during 1995-2009.

    3 Source: Barclays. As of October 2022.

    4 Source is J.P.Morgan. As of October 2022.

    5 Source: J.P.Morgan. As of September 2022.

    6 Source: J.P.Morgan. As of Q3 2022.

    7 Definition taken from Moody's Investors Service.

    8 Source: J.P.Morgan. The share in the broad diversified index is 22%. As of October 2022.

    9 Insights from our EM economists suggest sovereign stress is isolated, not broad-based, and largely confined to smaller, low-income economies that are a large share of the index. the market appears to be differentiating between sovereign borrowers based on macro fundamentals, implying the risk of a “traditional” EM crisis is low.

    10 Source: J.P.Morgan. As of October 2022.

    11 Source: Goldman Sachs Asset Management. As of November 10, 2022.

     

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    This document has not been, and will not be, registered with or reviewed or approved by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or Qatar Central Bank and may not be publicly distributed. It is not for general circulation in the State of Qatar and may not be reproduced or used for any other purpose.

    Saudi Arabia: FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. If you do not understand the contents of this document you should consult an authorised financial adviser.

    FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    These materials are presented to you by Goldman Sachs Saudi Arabia Company ("GSSA"). GSSA is authorised and regulated by the Capital Market Authority (“CMA”) in the Kingdom of Saudi Arabia. GSSA is subject to relevant CMA rules and guidance, details of which can be found on the CMA’s website at www.cma.org.sa.

    The CMA does not make any representation as to the accuracy or completeness of these materials, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of these materials. If you do not understand the contents of these materials, you should consult an authorised financial adviser.

    UAE: FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    This document has not been approved by, or filed with the Central Bank of the United Arab Emirates or the Securities and Commodities Authority. If you do not understand the contents of this document, you should consult with a financial advisor.

    Israel: FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    This document has not been, and will not be, registered with or reviewed or approved by the Israel Securities Authority (ISA”). It is not for general circulation in Israel and may not be reproduced or used for any other purpose. Goldman Sachs Asset Management International is not licensed to provide investment advisory or management services in Israel.

    Index Benchmarks

    Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

    The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.

    Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

    Confidentiality

    No part of this material may, without Goldman Sachs Asset Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

    © 2023 Goldman Sachs. All rights reserved.

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