Based on our perspectives, we believe the EM US dollar corporate debt sector continues to present compelling prospects. To help discern opportunity relative to risk, we present five viewpoints on emerging market debt:
When compared with the leverage profile of their US counterparts, EM corporations appear to be on a firmer footing. Following the commodity downturn of 2015 and 2016, EM corporations tied to the oil and gas and metals and mining sectors undertook broad-based deleveraging efforts. Simultaneously, the Chinese government adopted policy measures targeted at reducing leverage within the corporate system. As a result, we see EM corporates as well positioned to weather the COVID-19 crisis.
US Dollar Debt Burden
We believe most EM corporate issuers that access the US debt funding markets have learned from past currency crises. Most either have natural hedges via hard-currency revenue (e.g., commodity exporters) or financial hedges. Ensuring bonds are appropriately hedged is a key pillar of the Loomis Sayles credit research process. For the broad market, we see some lower-rated issuers vulnerable to currency losses, but we do not expect foreign exchange mismatches to drive an uptick in defaults.
While 2020 default rate expectations have been revised higher, from 2.4% to 4.8%,1 this rate is below the most recent peak of 5.1% in 2016. We expect resilient credit metrics, prefunding activities and proactive liability management exercises to help mitigate default rates in EM. Importantly, oil and gas companies in EM, unlike those in developed markets, are mostly investment grade with partial government ownership. Notably, many EM corporate issuers have access to onshore funding markets. This is especially important for Chinese issuers who may find onshore funding channels more accommodative during this period of global financial stress.
Given the pressure on credit ratings and concern about rising default rates, the investment environment could be witnessing uncertainty translating into opportunity. We believe that valuations are attractive. The global spread of COVID-19 resulted in a broad-based repricing of EM credit risk. As of May 8, 2020, the option-adjusted spread (OAS) on the J.P. Morgan Corporate Emerging Market Bond Index was approximately 223 basis points wider versus the start of the year.
Examining the relationship between spread and ratings, we see spread levels offering ample space for additional credit downgrades. This is especially true when we consider the number of downgrades that have already materialized. In March and April, the acceleration of downward ratings actions turned the trend negative, and it is nearing the trough previously observed in 2016 commodity downturn.
Given current valuations, the potential for further downgrades is, in our view, priced into the market as the index OAS (★) reflects a BB rating. For many names, forced selling and technical pressures have led to bond price dislocations that might offer investors attractive investment opportunities.
Maintain EM US Dollar Corporate Debt Allocation
While we recognize uncertainty is uncomfortable, EM debt offers distinct characteristics to an overall portfolio. Central to these is its tendency to generate a meaningful part of returns during recovery periods that follow acute market dislocations. The typical EM yield cushion has the potential to be an additional buffer to either absorb additional spread widening or deliver elevated returns if spreads levels remain unchanged.
It has paid to stay invested over the long horizon and we don't believe this time is likely to be different. Historically, in the years that follow important economic shocks, EM returns exceeded those of US investment grade corporates or Treasurys. In other words, as the cycle switched from one cycle phase to another—downturn to recovery and credit repair—EM returns significantly outpaced those of higher-rated benchmarks.
Importantly, investors who migrated to more conservative strategies during a recovery period missed potential returns without materially lowering long-term volatility. The result was not only lower returns, but also lower risk-adjusted returns than if they had stayed invested in EM.
Below, we compare a consistently invested EM corporate portfolio with a portfolio rebalanced to US investment grade after each shock, and then rebalanced back to EM after one year. Note that such an allocation strategy largely missed the EM recoveries. We believe a consistent EM corporate allocation can offer compelling risk-adjusted returns versus a market-timing alternative.
EM corporate credit brings a distinct set of characteristics to a portfolio. From our perspective, it continues to present a compelling investment opportunity. Of course, parsing through the fundamentals and accurately determining risks relative to potential gains remains critical.
1 Source: JP Morgan as of March 31, 2020.
This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the Emerging Market Debt team only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Information obtained from outside sources is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
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Market conditions are extremely fluid and change frequently.
Past performance is no guarantee of, and not necessarily indicative of, future results.
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