Despite macro challenges, emerging-market high-yield credit shows potential
Rising inflation, hawkish central banks, Russia’s invasion of Ukraine, COVID-19 lockdowns in China, diminished economic growth expectations—there’s been no shortage of challenges this year for risk assets globally.
Double-digit losses in fixed income, such as those investors have confronted year to date, are rarely seen and never comforting. The uncertain outlook for the second half of the year—and beyond—has been exacerbated by diminishing liquidity conditions, lackluster technicals, and skittish investor sentiment. Against such an arduous macro environment, conviction is difficult to find.
While conviction is understandably hard to come by given such headwinds, we believe that maintaining investment discipline, sticking to a proven process, and focusing on a longer-term time horizon is the best strategy for uncertain markets. In fact, we’re seeing compelling opportunities in emerging-market (EM) corporate credit at current levels, particularly in the high-yield segment of the market.
Valuations are exceptionally low—especially for investors with dry powder
While the outlook for the global economy is far from rosy, the high-yield segment of EM corporates appears priced for calamity. After more than 200 basis points (bps) of year-to-date spread widening, the yield on the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified High Yield Index is now 10.3%. That level puts the current yield in the 99th percentile over the past 10 years, more than two standard deviations away from the long-term median and more than 325bps above that level. Historically, starting to deploy capital when yields are this high has proven prudent: Spread compression over the next 12 months has averaged more than 480bps. On a total return basis, after the peaks in spreads in 2016 and 2020, the next 12 months produced gross average returns of 27.4%. There’s no guarantee that valuations have hit rock bottom, but today’s yield levels have historically offered compelling return potential, not to mention strong carry while investors wait on the eventual economic recovery.
Valuations in high-yield EM credit have rarely been this attractive
Source: Bloomberg, as of July 15, 2022. YTW reflects yield to worst. The J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified High Yield Index tracks U.S. dollar-denominated debt issued by emerging-market corporations. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Fundamentals are still quite strong across multiple measures
Despite the numerous macro headwinds, fundamental strength across EM credit remains very strong:
- Reasonable leverage—EM corporate leverage levels may still end 2022 lower than where they started the year, despite the negative backdrop and the likelihood of modest margin contractions from their record-high levels. Lower leverage suggests a company is in a better position to meet its financial obligations, all else being equal.
- High profitability—Corporate EBITDA (a common measure of profitability) looks poised to increase by around 10% this year, with the most favorable dynamics found in Latin America and the Middle East and Africa (7% and 25%, respectively).1 All of these regions directly benefit from higher oil prices, higher volumes/consumption, and are better able to pass off inflated costs. These levels of profitability mean that gross leverage in EM credit looks poised to decrease by a quarter of a turn this year, which reflects the ratio of a company’s profits versus its debt; lower turns mean higher profit levels relative to debt. These improving conditions have been driven primarily by commodity-producing countries, the notable exceptions, unsurprisingly, being Russia and Ukraine.
- Solid fundamentals—EM corporate fundamentals have remained resilient year to date, with revenue up 25% year over year, EBITDA positive in Q1, and debt levels stable as companies tightened their belts in preparation for tougher times ahead.
Not only does EM credit look attractive on its own for these reasons, but it offers a particularly compelling relative value proposition for global investors; on a spread per turn of leverage basis, EM high-yield credit offers around 300bps—or approximately three times the spread—of U.S. high-yield companies relative to a long-term average of two times.
EM high-yield credit offers meaningfully higher yield-to-leverage ratios than high-yield corporates in the United States
Spread per turn of leverage: EM high yield vs. U.S. high yield
Source: ICE BofA, as of July 15, 2022. A turn of leverage is the ratio of a company’s debt to its earnings. Two turns of leverage means a company’s outstanding debt equals twice its annual earnings. The Intercontinental Exchange (ICE) Bank of America (BofA) High Yield Emerging Markets Corporate Plus Index (Global EMHY) tracks the performance of below-investment-grade corporate debt issued in emerging markets. The ICE BofA U.S. High Yield Index (USHY) tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below. It is not possible to invest directly in an index.
Defaults to date—and going forward—are likely limited to a handful of segments
The outlook for EM corporate default rates for 2022—excluding Russia (which has been delisted from global indexes), Ukraine, and Chinese real estate companies—calls for a relatively benign 0.5%, lower than the 0.8% expected default rate in the U.S. high-yield market. The overwhelming majority of anticipated defaults are linked either to the embattled China property market and to emerging Europe, where the invasion of Ukraine has had the most direct impact. Other regions’ default rates have remained at attractively low levels: Year to date, Latin America’s default rates are at roughly 1.0%, while the Middle East and Africa hover at essentially zero. While high-yield securities by their nature will carry a heightened level of default risk, a disciplined, active credit analysis process is designed to identify the more compelling risk/reward opportunities available.
EM HY default rates are up, but almost exclusively within a narrow segment of the market
Source: J.P. Morgan, as of June 30, 2022. "Ex RU/UA/CN prop" refers to the high-yield emerging-market credit universe excluding the debt of Russia, Ukraine, and China property developers.
None of this is to suggest the challenges facing EM aren’t significant; the headwinds facing the global fixed-income markets this year have rarely been so severe. But despite these challenges, we see a number of encouraging signs, especially in EM high-yield corporates, that we believe make the segment worthy of considerations for investors with long enough time horizons to weather the current storm.
1 J.P. Morgan, as of June 30, 2022.
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