The fast growth of the emerging corporate bond market in recent years is widening the opportunity set in the asset class. The hard currency corporate bond sub-asset class has doubled in size since 2010, and is now worth over $1.3 trillion – on a par with the US high yield market.
With the inclusion of local-currency bonds, the Bank of International Settlements estimates that the total emerging market corporate bond market was worth nearly $4 trillion at the end of 2013.
From a current valuation perspective, emerging market corporate bonds can be attractive relative to their developed market counterparts after steadily decent performance from the latter. However, investing on a selective basis with careful and thorough credit research remains key.
For a similar bond rating class, emerging market corporate credit is offering higher spreads than in the US and Europe, suggesting that investors are being compensated for the credit risk as well as receiving a premium for investing in emerging market assets:
Source: Bloomberg 30 September 2014
Credit: Attention to quality
The easy money has clearly already been made in corporate and high yield bond markets. Since the height of the credit crisis, spreads on investment grade have tumbled from a peak of 511 basis points in 2008 to around 123 bps today, and in high yield, from 2,193 bps to 488 bps over the same period.
The good news is that in every rating bucket except for CCC, investors are still being overcompensated for default risk – in other words, credit spreads imply a higher level of defaults than we would expect to see:
Source: Five year rolling default rate: Moody’s, Deutsche Bank
Implied default rate: BoA Merrill Lynch, Bloomberg 30 November 2014
The bad news is that most of that excess spread is likely to be a premium for illiquidity, which is not necessarily a problem for long-term investors, but could be a potential source of volatility in the shorter term.
While there are signs of some bad behaviour returning to credit markets, this is on a much smaller scale than in the years before the credit crisis in 2008. Nevertheless, animal spirits do appear to be returning – especially in the US – as evidenced by rising levels of corporate debt, increased merger and acquisition activity and an upsurge in the issuance of lower rated CCC bonds and ‘payment-in-kind’ debt (PIK notes).
Dividend payments and share buybacks are also increasing, although healthy corporate profit margins appear to be having only a limited impact on capital expenditure so far, which is a shame for global growth.
While the global default rate is still extremely low, a few warning signs probably suggest that it is time to start paying closer attention to deteriorating credit quality. Overall, companies still have lots of (arguably too much) cash on their balance sheets, but there are a few signs that profit margin growth has reached an end.
A number of high yield businesses have run into problems this year, and while each has been the result of specific issues that were unique to those companies, it does perhaps highlight a general trend of complacency amongst high yield investors. On the other hand, an increase in distressed debt can be a source of opportunities; where we believe the underlying business is robust and the bondholder’s legal position strong, we many occasionally invest in distressed debt instruments.
As the experience of the past few years has aptly demonstrated, making bold predictions for bond markets for the coming year requires no small measure of bravery.
Nevertheless, with substantial volumes of QE still on the horizon in a number of globally significant economies such as Japan and the eurozone, the prospect of deflation rather than inflation keeping central bankers awake at night, and the timing of interest rate hikes being pushed out in nearly all economies, it does not need a huge leap of faith to say that conditions for bond investors currently look relatively benign.
Equally, as the start to 2014 showed, all it takes is a few stormy months – literally or figuratively – for all best estimates to fall by the wayside.
