Busting myths of EM debt

Emerging market debt issuers are often assumed to be inherently less creditworthy than their developed market counterparts, but in our experience the reality tells a different story.

For one thing, in recent years emerging market (EM) default rates have not been materially greater than those in developed market, (DM) and the formers’s bond covenant quality has also tended to be higher on average.

Within the high yield (HY) area of EM debt, fundamentals are also improving and default rates are expected to decline this year.

Comparing default rates for EM corporate HY issuers with those of their US equivalents since 2000, two observations are worth highlighting. First is the close similarity in trend between the two series which suggests global cyclical factors, rather than regional idiosyncrasies, explain a large part of the default experience for both EM and US corporate issuers. Second, the magnitude of default rate has been broadly similar across cycles, with 2002 the only meaningful exception in the period surveyed.

Similarly, when we consider EM Sovereign defaults we can see how credit events have become more of a rarity. Using JPMorgan’s Emerging Market Bond Index (EMBI) Global benchmark to represent the investable hard currency EM sovereign issuers accessible to international investors, only seven EM sovereigns in the index have defaulted since 2000. The adoption of flexible exchange rates, strengthened external balances, reserve accumulation and a move from external to local currency debt issuance go some way toward explaining this shift.

Rodica Glavan – Insight Investment, a BNY Mellon company

Emerging market debt issuers are often assumed to be inherently less creditworthy than their developed market counterparts, but in our experience the reality tells a different story. For one thing, in recent years emerging market (EM) default rates have not been materially greater than those in developed market, (DM) and the formers’s bond covenant quality has also tended to be … read more

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The key to unlocking value in high yield bonds

The market value of the US and European high yield markets has doubled and tripled respectively over the last decade. This is partly because, since the global financial crisis, fewer corporates have been able to receive financing from banks and have turned to non-bank alternatives (such as bonds) instead.

While we believe a nuanced approach to investing in high yield bonds can be beneficial we also view it as a specialist investment area and demanding substantial skill and resource.

Understanding a company’s business profile is one way of mitigating some of the risks associated with investing in the asset class – but to do so requires extensive SWOT analysis and competitor reviews. Free cash flow is one way of determining the issuer’s financial viability. Most companies, both IG and HY do not generate sufficient cash to repay bond debt. HY companies have a greater emphasis on generating free cash flow and this provides a path to refinancing and overall credit quality improvement. The ability for the company to call (redeem early) or not call its bond can also directly impact its value.

At the same time, the terms and conditions regarding a high yield bond can be complicated and term sheets are frequently several hundreds of pages long. They include details regarding structural protections such as seniority (the bond’s priority in the capital structure), security against company assets and debt covenants. The latter can help ensure a bond’s credit quality is not compromised by company management.

A company’s liquidity is another crucial determinant of its ability to repay. When investment grade companies have no cash available to repay the bond’s principal, they can usually draw on a revolving credit facility. However, high yield companies will not typically have a facility that is large enough. Furthermore, for high yield companies the facility is typically secured against inventories, further blocking available sources of liquidity.

Uli Gerhard – Insight, a BNY Mellon company

The market value of the US and European high yield markets has doubled and tripled respectively over the last decade. This is partly because, since the global financial crisis, fewer corporates have been able to receive financing from banks and have turned to non-bank alternatives (such as bonds) instead. While we believe a nuanced approach to investing in high yield … read more

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UK inflation in context: three key charts

The return of inflation has been one of the dominant themes since the start of the year. Economic data in Europe and the US have both surprised on the upside while in the UK fears of deflation, which were so much a part of 2016, now seem a long-distant memory.

This is borne out by the latest figures from the Office for National Statistics whose Consumer Prices Index (CPI) jumped to 2.3% in February, up from 1.8% in January. This breaches the Bank of England’s 2.0% target and the bank itself has said it expects inflation to peak at 2.8% next year.

Two things are at play here: first, sterling’s weakness since the Brexit decision has increased the cost of imports; second, the increase in commodity prices, particularly oil, has had a knock-on effect through the rest of the economy.

Meanwhile, even as inflation begins to rise, UK interest rates remain at an all-time low of just 0.25%.

As inflation rises, we believe the Bank of England will consider tightening monetary policy, which in turn would increase pressure on bond pricing, particularly towards the long end of the maturity spectrum. Now more than ever we think it makes sense for investors to consider inflation protection strategies for their portfolios to preserve the value of future cash flows.

David Hooker – Insight, a BNY Mellon company

The return of inflation has been one of the dominant themes since the start of the year. Economic data in Europe and the US have both surprised on the upside while in the UK fears of deflation, which were so much a part of 2016, now seem a long-distant memory. This is borne out by the latest figures from the … read more

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Commodities form a link in the virtuous circle for emerging markets

While the fortunes of emerging markets are not solely tied to the outlook for commodities, the recent bounce offers yet another reason to be optimistic.

The rally in commodity prices over the past six months has been fairly broad based and this will have an obvious benefit to commodity- exporting countries as, all things being equal, one would expect higher nominal exports to translate into stronger economic growth for export-dependent economies.

Rising commodity prices can help improve these countries’ balance of payments position and, in turn, reduce current account deficits. Currencies of commodity exporters are also likely to be well supported, something which could potentially raise the appeal of local currency strategies.

Since the end of last year, key exporters. such as Russia and Brazil, have demonstrated a strong pick-up in economic growth. But other major importers, such as China, are also faring well, highlighting the positive effect of other key themes at play in the emerging world.

Global data across both the developed and emerging world continue to improve—marking the first co-ordinated cyclical upswing for many years. The cyclical growth backdrop remains supportive for emerging market assets and current conditions have historically been associated with increased capital flows in to emerging economies. In combination, these factors could override the dampening effects of political and fiscal uncertainty stemming from the developed world.

Rodica Glavan – Insight, a BNY Mellon company

While the fortunes of emerging markets are not solely tied to the outlook for commodities, the recent bounce offers yet another reason to be optimistic. The rally in commodity prices over the past six months has been fairly broad based and this will have an obvious benefit to commodity- exporting countries as, all things being equal, one would expect higher … read more

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The global uncertainty principle and why investors should care…

The basic assumption by markets at the moment is that President Trump and the Republican administration will engage in fiscal stimulus. The question to ask is whether that fiscal stimulus is successful or whether it will end in failure. If it is successful then perhaps it will lead to US dollar strength and growth both in the US and the rest of the world and perhaps even a normalisation of the US Treasury curve. If it doesn’t succeed, as many people expect, then likely there will be a reversal of market expectations, an increase in policy uncertainty and perhaps a lower growth profile than currently priced in. These two routes have very different outcomes for the prospects of emerging market fixed income and equity markets.

There are some variables around this. First, think about President Trump and his tweets: they generate a significant amount of headline risk as we have seen already in the early weeks of his administration. That in turn creates uncertainty and perhaps a higher risk premium for some of the emerging markets such as China and Mexico and even for developed markets like Europe. It is too early to tell the result of this rhetoric but there is definitely a whiff of protectionism in the air.

The other variable is whether the Republicans in control of Congress have a high enough tolerance to increase the deficit in order to engage in this type of fiscal stimulus, which is not particularly clear to us at this point. Putting all this together, we believe the level of uncertainty in markets is going to fluctuate a lot over the next few months.

Colm McDonagh – Insight, a BNY Mellon company

The basic assumption by markets at the moment is that President Trump and the Republican administration will engage in fiscal stimulus. The question to ask is whether that fiscal stimulus is successful or whether it will end in failure. If it is successful then perhaps it will lead to US dollar strength and growth both in the US and the … read more

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Heavy weather for BoE inflation forecasts?

Market pricing would suggest investors are anticipating a prolonged period in which inflation overshoots the Bank of England’s (BoE) inflation target. The BoE asserts any pickup in inflation is likely to be temporary. As market expectations and official inflation forecasts fall further out of sync, the reality that emerges will have significant implications for holders of nominal and inflation-linked bonds alike.

The BoE’s rate-setting committee, the Monetary Policy Committee (MPC), has been reluctant to increase official rates in the face of higher inflation, owing to what it considers to be temporary factors. And, for now, it can point to public expectations for UK inflation being relatively well contained. This is reminiscent of 2011, when the BoE “looked through” price rises at a time when commodity prices were soaring and value-added tax was being increased. Inflation, as measured by the consumer price index, peaked above 5% that year.

Holders of nominal bonds need to be certain that the current increase in inflation is being driven by temporary factors, as the MPC asserts. If the BoE’s assessment is flawed, its commitment to low inflation will be questioned for the second time in recent history. This would arguably have serious implications for holders of nominal bonds, more so than owners of inflation-linked assets.

David Hooker – Insight, a BNY Mellon company

Market pricing would suggest investors are anticipating a prolonged period in which inflation overshoots the Bank of England’s (BoE) inflation target. The BoE asserts any pickup in inflation is likely to be temporary. As market expectations and official inflation forecasts fall further out of sync, the reality that emerges will have significant implications for holders of nominal and inflation-linked bonds … read more

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M&A: boon or burden?

One important challenge for corporate bond investors in 2017 will likely be a continuing rise in idiosyncratic credit risks in investment grade markets. A significant contributor is a wave of M&A activity, which often benefits a company’s shareholders at the expense of its bondholders. In a low growth environment, management teams struggle to deliver shareholder growth organically and so M&A or shareholder buybacks become a natural solution. However, this usually leads to an uptick in leverage ratios, which is a risk for credit investors.

Issues surrounding corporate governance are another factor. Examples include last year’s Volkswagen scandal and this year’s controversy surrounding Deutsche Bank and the US Department of Justice.

That said, we do expect stable, positive economic growth across the US and Europe next year and this should create a supportive environment for credit. At the same time, some of the tailwinds that drove the asset class in 2016, notably the ECB’s corporate bond purchase programme, are likely to fade away, and we are mindful of that.

For more insight into what the next 12 months might hold for investors, please visit the BNY Mellon Markets 2017 special report.

Lucy Speake – Insight, a BNY Mellon company

One important challenge for corporate bond investors in 2017 will likely be a continuing rise in idiosyncratic credit risks in investment grade markets. A significant contributor is a wave of M&A activity, which often benefits a company’s shareholders at the expense of its bondholders. In a low growth environment, management teams struggle to deliver shareholder growth organically and so M&A … read more

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Why not all inflation measures are created the same

Central banks have long adopted inflation targeting on the premise that low and stable inflation will promote long-term economic growth. But in our view there are inherent problems associated with inflation targets, particularly when it comes to deciding which inflation measure to use.

The Federal Reserve (Fed), for example, targets the price inflation measure for personal consumption expenditures (PCE) at 2%. Like most central banks, the Fed targets the core inflation measure, arguing that volatile factors such as food and energy prices should be stripped out.

But, what if core PCE is giving a misleading picture of inflationary pressures in the US economy? Each measure of price inflation has components that are weighted differently and the sensitivity of each to the business cycle can vary. Some sectors may also be more prone to experiencing large idiosyncratic shocks compared to others. Other forms of aggregation can be used, further complicating the picture.

The suggestion that the inflation target itself may be flawed is interesting, given the effort investors pour into dissecting every line of monetary policy communication from central banks for clues as to the next move in interest rates or, as the case has been more recently, unconventional policy settings. The issue reminds this fund manager of Goodharts law, named after Charles Goodhart a former advisor to the Bank of England who first opined in 1975 that “when a measure becomes a target, it ceases to be a good measure”.

David Hooker – Insight, a BNY Mellon company

Central banks have long adopted inflation targeting on the premise that low and stable inflation will promote long-term economic growth. But in our view there are inherent problems associated with inflation targets, particularly when it comes to deciding which inflation measure to use. The Federal Reserve (Fed), for example, targets the price inflation measure for personal consumption expenditures (PCE) at … read more

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Dispelling EMD preconceptions

We believe EM corporate debt is supported by falling yields in the developed world as they turn negative out to ever increasing maturities. Investors, concerned by global risks, are accepting losses on their capital but are, in our view, overlooking the risks embedded in developed markets at current levels, underscoring the pervasiveness of the current negative yield environment.

Furthermore, we believe growth in EM is on course to reach an economic inflection point this year as fundamentals continue to improve. In our view, investing in EM corporates is about capturing the structural premium offered over their developed market counterparts as EM countries gain an increasing share of global GDP.

Put differently, the active management of EM corporate debt can give investors the optionality to scale into different risk and return drivers according to their objectives. These credits tend to be under-researched, under-owned and unloved by mainstream investors, which can create mispricing and opportunity in spite of its status as a rapidly maturing asset class.

By Robert Simpson – Insight Investment, a BNY Mellon company

We believe EM corporate debt is supported by falling yields in the developed world as they turn negative out to ever increasing maturities. Investors, concerned by global risks, are accepting losses on their capital but are, in our view, overlooking the risks embedded in developed markets at current levels, underscoring the pervasiveness of the current negative yield environment. Furthermore, we … read more

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What lies beneath: The hidden truth of EM commodities

Emerging market (EM) countries have borne the brunt of the recent commodity price collapse: the Institute of International Finance estimates global investors pulled US$735bn out of emerging market bonds and equities in 2015, the worst capital flight in 15 years.[1]

But we believe the popular view of emerging markets as predominantly commodity-dependent net exporters – is a mistaken one. For some EM countries, energy is a key export; while for others (Latin America, for example) exports are predominantly soft commodities and metals. In Asia, with one or two exceptions, countries are mainly net importers, particularly of energy. Across emerging markets, just 44% of countries are net exporters, while 56% are net importers.[2]

We think these nuances matter. They demonstrate the importance of viewing emerging markets not as one monolithic whole but rather as a broadly differentiated set of investment opportunities and challenges.

Rodica Glavan – Insight, a BNY Mellon company

[1] Bloomberg: ‘Emerging Markets Lost $735 Billion in 2015, More to Go, IIF Says’, 20 January 2016

[2] JP Morgan: ‘EM exposure and vulnerability to commodities revisited’, 9 March 2016

Emerging market (EM) countries have borne the brunt of the recent commodity price collapse: the Institute of International Finance estimates global investors pulled US$735bn out of emerging market bonds and equities in 2015, the worst capital flight in 15 years.[1] But we believe the popular view of emerging markets as predominantly commodity-dependent net exporters – is a mistaken one. For … read more

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