Lessons from Past Emerging Markets Cycles: Part II (Bonds) In the past five years, the size of Emerging Market corporate and sovereign bonds has increased by over %. This highlights the increasing need of investment for EM to continue growing. Although currently the size of EM bond market is pale compared to U.S. bond market alone, at less than % of U.S. total market cap, this number will certainly grow larger going forward and take a greater proportion of global investor s portfolio. As a reference, EM equity market cap today is around 19% of its U.S. counterpart and 1% of world total. It is noted that although EM equity market cap is 11% of world total, EM average equity allocation is only %. And within bond space, investors only allocate 1-% of their portfolio into EM debt. Both are consistent with the view that investors 1 (Amundi Asset Management) have been overlooking EM assets. 1, Emerging Market Bonds Market Cap Corporate U.S. Dollar Denominated Sovereign U.S. Dollar Denominated 1, 1, U.S. Bonds Market Cap Corporate and High Yield Treasury and Agency 1, 9 9 1, 1, 1, 1, 7 7,, 1, 1,,,,, 213 21 21 21 217 21 219 213 21 21 21 217 21 219 Figure 1. EM and U.S. Bonds Market Capitalization Adding EM bonds into a fixed income and global portfolio also makes sense, especially for EM Investment Grade corporate bonds, due to the diversification benefit and attractive risk-reward ratio relative to U.S. equivalent securities. Granted, EM corporate bonds are deemed to be riskier due to the currency mismatch between corporate revenue and its dollar debt, hence the higher yield and return potential. Figure 2. EM and U.S. Bonds Risk and Return
EM Bond Spread Over U.S. Equivalent Securities: Sovereign Bond Investment Grade Corporate High Yield Corporate 3 2 1 2 21 21 21 Figure 3. EM and U.S. Bond Spread 3 2 1 EM minus U.S. sovereign spread are the widest relative to its IG and HY counterparts for the reason that countries borrowing in hard currency tend to be those that are riskier and unable to issue debt in local currency. However, it is interesting to see that EM high yield bonds are trading at a lower spread than investment grade corporate bonds despite the added distress from currency fluctuation and mismatch. In figure, our suspicion is validated that EM high yield bonds should be trading at a much higher spread to offset the losses from default, as highlighted by the lower return of EM HY relative to U.S. HY despite the slightly higher yield. EM sovereign and investment grade corporate are behaving as expected by trading at a higher yield and producing higher return. The bottom line is that EM sovereign and investment grade corporates are an attractive asset class to be added for diversification and enhancement of portfolio return. 3 Bond Return* 3 Bond Yield 3 3 7 7 2 2 2 2 1 1 3 3 1 1 2 2 1 1 US HY EM HY EM Sovereign EM IG US IG US Treasury EM HY US HY EM Sovereign EM IG US IG US Agency US Treasury *Since September, 2 Figure. EM and U.S. Bond Return and Yield
Performance of Emerging Markets Bond in Various Cycles Despite the prejudice that EM assets are always suffering during market volatility, we found the opposite to be true for EM corporate bonds. It posted a slightly positive return during the recession compared to the negative return of its U.S. counterpart. And within period of rising Fed rate, the asset class outperformed, but due to the higher weighting in high yield securities and not due to the better performance of the securities itself. Investment grade securities constitute % of U.S. corporate bond market and only % of EM. Consistent with our precious thesis, EM HY tend to lag the performance of U.S. HY. EM local currency bond (GBI) performance is more mixed, with positive return during rising rate by the Fed and PBoC, while exhibiting negative return during PBoC easing cycle. Figure. Performance of Emerging Markets Bond in Various Cycles CEMBI Weight Investment Grade High Yield Figure. EM Corporate Bonds Weight
Spread per Turn of Leverage for EM Corporate Bonds 7,,, U.S. Corporate Bonds Market Cap AAA AA A BBB BB B CCC and Lower 7,,,,, 3, 3, 2, 2, 1, 1, 2 2 21 21 1 1 1 Spread per Turn of Leverage*: EM Corporate Bonds U.S. Corporate Bonds 1 1 1 Since the rating composition of EM and U.S. corporate bonds differ significantly, we need to standardize the return relative to risk in order to assess the attractiveness. Spread per turn of leverage is a metric commonly used to assess the relative riskreturn for bonds market, it is calculated by dividing bond spread to net debt to EBITDA ratio. The current EM corporate bonds TOL 1 1 is 2.3x, almost twice of U.S. TOL (1.2x). Although this means that EM provides more value for each unit of risk taken, we need to keep in mind of several additional risk that is not captured in the metric, such as: 2 2 1 1 1 1 *Bond yield spread over U.S. treasury divided by net debt to EBITDA ratio 2 Distribution of leverage within EM and U.S. corporates, whether it is dispersed or more concentrated The cyclicality of companies in each asset class Mismatched exposures in maturity or currency, or both
Emerging Markets Corporate Bonds CEMBI Sector Weight Consumers Financials Industrials Infrastructures Metals & Minings Oil & Gas Pulp & Paper Real Estate Technology, Media & Telecommunication Transports Utilities CEMBI Country Weight Brazil China Hong Kong India Mexico Russia Others (<%) 1 1 CEMBI Country Yield 1 1 1 1 1 1 JM UA KZ TR RU NG BR CN ID IL MO CO ZA MX PH PE HK IN CL AE SG KW MY KR EG TH SA BH QA PL TW CEMBI Country Return* 3 3 2 2 1 1 KZ KW MO PL UA RU PH *Since September, 2 IN ID ZA AE CN TH CL PE IL JM BH SG MY MX HK TR QA KR BR CO SA
7. CEMBI Sector Yield 7. 3 CEMBI Sector Return* 3 3 3 7.2 7.2 2 2.. 2 2 1 1.. 1 1... Real Estate Mining & Metals Transports Financials Industrials Consumers Infrastructures Oil & Gas Technology, Media & Telecommunication Utilities Pulp & Papper. - *Since September, 2 Pulp & Papper Industrials Real Estate Consumers Financials Mining & Metals Transports Utilities Technology, Media & Telecommunication Oil & Gas Infrastructures - 11 1 CEMBI Rating Yield 11 1 32 3 CEMBI Rating Return* 32 3 9 9 2 2 2 2 2 2 7 7 22 22 2 2 1 1 1 1 C NRT B NIG BB BBB IG A AA NRT NIG BB B BBB A IG AA C *Since September, 2
Emerging Markets Sovereign Bonds EMBI Country Weight EMBI Rating Weight AR BR A CL CN BBB CO EG BB HU ID B IN LK C MX MY Not Rated Others PE PH PL RU TR VE VN ZA EMBI Country Yield 3 3 2 2 1 1 VE AR EG LK TR MX ZA BR RU ID CO CN PE CL IN MY VN HU PH PL EMBI Country Return* 2 2-2 -2 AR HU VN EG LK ID IN RU CN PL PH CL PE CO BR MY ZA MX TR VE *Since September, 2 except f or India, which started f rom October 1, 2
3 3 9 EMBI Rating Return* 9 3 EMBI Rating Yield 3 2 2 7 7 2 2 1 1 1 1 3 3 2 2 C NIG B NRT BB BBB IG A C NRT A BB B NIG IG BBB *Since September, 2
Emerging Markets Local Currency Sovereign Bonds GBI Country Weight AR CL CO HU ID MX PH RU TH BR CN CZ IN MY PE PL ZA TR 2 2 GBI Country Yield 1 1 AR TR ZA MX BR RU ID IN CO Index PH PE CL MY CN TH PL HU CZ GBI Country Return* 2 2-2 -2 - - - - - - ID PE TH BR IN CN HU PL Index CO MY ZA MX RU TR CL AR *Since September 29, 29
U.S. Bonds 2, 1, U.S. Bonds Market Cap Treasury Securities Agency Securities Investment Grade Corporate Securities High Yield Corporate Securities 2, 1, 3 3 US Securities Type Return* 1, 1, 3 3 1, 1,,, 2 2 1, 1, 2 2,,,, 1 1,, 1 1 2, 2, 2 2 21 21 Corporate HY Corporate and HY Corporate IG Agency Treasury and Agency Treasury *Since September, 2 11 1 U.S. Bond Yield 11 1 US Securities Rating Return* 9 9 3 3 3 3 7 7 2 2 2 2 1 1 AAA AA A BBB BB B CCC CCC HY BB B BBB IG A AA AAA *Since September, 2
Drawdown from 3-Year Peak of Emerging Markets and U.S. Bond Securities
Kevin Yulianto, PFM