In-depth insights from NN Investment Partners FocusPoint The Case for Emerging Market Corporate Debt NN Investment Partners Corporate Emerging Market Debt team illustrates the attractiveness of emerging market corporate debt in a world of low yields. The rapid development, depth and maturity of the emerging markets corporate debt asset class merits a standalone allocation The asset class provides attractive income potential in a world of negative bond yields Fundamentally driven active management is the best way to exploit the inefficiencies of emerging markets fixed income www.nnip.com
Emerging Market Corporate Debt: Attractive asset class in a low-yielding world Introduction More than US$ 1 trillion 1 of fixed income securities trade with yields below zero. The universe of sub-zero yielding debt consists primarily of European and Japanese government bonds as their governments implement quantitative easing programmes and negative central bank policy rates. An investor s reaction typically is to buy riskier products such as high-yield corporate debt but this also means taking concentrated, undiversified risks. An active management of emerging market (EM) corporate debt offers an attractive alternative. These credits are under-researched and under-owned by global investors, despite their growing maturity. 1. Background The EM corporate debt asset class is comprised of US dollardenominated debt issued by companies based in EM countries. As of September 216, there was US$ 846 billion of EM corporate debt in the JPMorgan CEMBI Broad Index, compared to US$ 28 billion in 1. Figure 1: Market value of EM corporate bonds Billions US$ 1 8 6 4 1 3 4 6 7 9 21 211 213 214 216 Middle East Latam Europe Asia Africa Source: JPMorgan, CEMBI Broad Index, July 216 The growth of the debt market coincided with the increasing sophistication of EM companies. Historically, global investors primarily invested in the external debt of sovereign and quasisovereign issuers. But as EM economies stabilised, their sovereign funding needs declined. At the same time, corporate issuance expanded as domestic companies matured. International investors became more comfortable as EM companies adopted international accounting standards and became more transparent. We believe that the rapid development, depth and maturity of the EM corporate debt asset class merits a standalone allocation. The universe has more than 1 outstanding issues and encompasses 44 countries. At the regional level, Asia and Latin America have the most amount of corporate debt outstanding, making up more than 7% of the market together. The financial sector is the largest segment, followed by Technology, Media and Telecoms (TMT), as well as Oil & Gas. 2. Current environment Better macro stability Macroeconomic risks have subsided in emerging markets. This year, Asia is expected to lead global growth once more. Although China s growth has eased, it is still expected to expand by 6.7% this year. The slowdown is partially engineered by Beijing, which has rightfully embarked on a rebalancing of its economy from industry to services in order to move to a more sustainable growth trajectory. Figure 2: GDP growth in emerging and developed markets Real GDP Growth (%) Country/Region 214 215 216f Asia ex Japan 6.4 6.1 5.7 China 7.3 6.9 6.7 EMEA 2.2.3 2.1 Latam 1 -.7-1.6 Developed 1.6 1.8 1.6 USA 2.4 2.4 2 Eurozone 1.4 2 1.5 Japan.6.8 Source: Bloomberg, NN IP, June 216 Elsewhere in Asia, India and Indonesia have also been implementing reforms to make it easier to invest and do business. In early August, India s government finally passed its goods and services tax (GST) bill after years of deadlock, which replaces the country s messy plethora of local, state and central taxes. In Latin America, Mexico has embarked on about a dozen major reforms in the last three and a half years, including opening the energy and telecoms sectors to competition, improving education and the criminal justice system. Elsewhere, many commodity exporters have made adjustments to survive in an environment of lower commodity prices. Prices have dropped sharply since 211 but many exporters have managed to improve their current account balances by broadening their tax bases (Middle East) or operate counter-cyclical fiscal policies (some Latin American and African countries). 1 According to Bloomberg data, 2
Figure 3: Current account balances have improved (% of GDP).5%.% -.5% -1.% -1.5% -2.% 3. The case for the EM Corporate Debt asset class Attractive income potential Government bond yields have turned negative in developed countries like Germany, France and Japan. Even highly-rated corporate issuers like Anglo-Dutch Unilever have securities due in 22 trading at a negative yield. Five-year US Treasury yields are still positive but they have dropped to 1.15% at the end of September this year from 1.4% a year ago. -2.5% -3.% 211 212 213 214 215 216 Figure 4: 5-yr government bond yields in developed markets 6% Commodity Exporters Commodity Importers ex-china Source: Haver Analytics, Morgan Stanley Research, March 216 Improving policy frameworks Policy frameworks in many emerging economies have generally improved over time. A study by the International Monetary Fund (IMF) this year found that governments have made strides in enhancing their debt management strategies, making economies less vulnerable to abrupt currency depreciations that could raise the foreign debt burden. Currency mismatch between assets and liabilities, which used to plague emerging economies, has been reduced. Meanwhile, inflation pressures are better contained, banking systems are generally healthier and local capital markets are deeper and better developed, which can provide more of a cushion in the event that foreigners withdraw from the market. These factors are the ones that are contributing to the current resilience of emerging markets to the post-21 slowdown in capital flows, which the IMF estimates to be the size and breadth of the major capital slowdown of 198s and 199s. Political and geopolitical risks still play a key role Although emerging economies have become more resilient as a whole, political and geopolitical risks still play a key role in EM investing. During the boom years, when China s demand seemed insatiable, countries were able to downplay their problems. Today, with slowing global growth and lower commodity prices, political instability risks have increased. For instance, investor sentiment towards Turkey abruptly turned sour in July as a failed coup organised by a faction within the Turkish Armed Forces led to the deaths of 3 people. As a result, Turkish credit spreads widened by 52 basis points (bps) over the month. In Poland, S&P downgraded its outlook on the sovereign, citing the new government s drive to take control of key institutions that should be independent. These risks, while idiosyncratic in nature, should not come as unexpected as political institutions are not as stable as those in the developed world. Investors have to be aware of the quality of governance when investing in emerging countries. 4% 2% % -2% Jul 6 Jun 7 May 8 Apr 9 Mar 1 US Germany Japan France Source: Bloomberg, September 216 Feb 11 In comparison, EM corporate debt was yielding 4.5% at the end of September 216, providing investors with an attractive income compared to alternatives in the developed world. Jan 12 Figure 5: Duration-adjusted yield levels Yield per unit of duration (%) 6 4 2 6 7 8 9 21 211 212 213 214 215 216 EM Corp ratio US Corp ratio EM yield (actual) Source: BofA Merrill Lynch, August 216 Compared to US corporates, EM corporate yields are also more attractive on a duration-adjusted basis, i.e. they yield more per unit of duration. At present, EM corporates have an interest rate duration of less than five years, compared to US corporates and EM sovereigns at seven years. This means that EM corporates are less exposed to changes in interest rates. Dec 12 Nov 13 Okt 14 Sep 15 2 15 1 5 Aug 16 Yield (%) 3
Figure 6: Spread vs. duration of different bond categories Spread level (bps) 4 3 1 EM Corp Asia Corp 3 4 5 6 7 8 Source: BofA Merrill Lynch, August 216 Duration (no. of years) EM Sov US Corp Although the pace of interest rate normalisation has been slow with the Federal Reserve only hiking rates once in December 215 interest rates are likely to go up. Spread products like EM corporate debt with lower interest rate sensitivity would prove more resilient in such an environment. Natural hedge against interest rate increases Since 2, the EM corporate debt market has delivered a cumulative return of more than %. The dip in 8 and 9 on the back of the global recession eroded returns but the market soon rebounded. Spreads widened overall since 2 but this was more than offset by the decline in US Treasury yields. Because spreads and interest rates tend to have an inverse relationship, credit is a natural hedge against interest rate increases. Similarly, when investors are more risk-averse, resulting in wider spreads, US Treasury yields are expected to fall, thus allowing the total return to remain steady. Figure 7: EM corporate debt returns and spreads 25 1 8 Index provides a diverse range of high-quality companies, from Singapore lender OCBC to Mexico s telecommunications company America Movil. In addition, companies face a cap on the number of notches above the sovereign that a corporate can be rated, which means that those operating in lower-rated countries naturally face more rating constraints than those in the developed world. In comparison, 54% of the EM sovereign bond index (EMBI Global Diversified Index) is made up of investment-grade bonds, a smaller percentage than the corporate bond index. Reduced currency risk As companies issue bonds in US dollars, investors are protected from fluctuations in EM currencies. EM currencies can be very volatile the Brazilian real and South African rand fell 33% and 25% respectively in 215. Investors who participate in US dollar debt do not have to worry about the direct impact of currency volatility on their investment returns. Investors may be concerned about the indirect impact of currency risks. Historically, EM corporates had mismatched assets (denominated in local currencies) and liabilities (in US dollars). Today, companies have learnt to rely on foreign funding to finance long-term capital expenditure (capex) rather than short-term needs. Additionally, many companies are naturally hedged as they are exporters, while others have taken the precaution to hedge their currency risks. Credit fundamentals Although credit fundamentals have weakened in emerging markets, we believe that the worst of the fundamental downturn has likely passed. To protect their credit metrics, many corporates have cut capex and reduced leverage by taking advantage of low interest rates to extend out to the curve. The oil and gas sector remains under stress but it should gradually see some reprieve as Brent oil prices have increased from US$ 37 per barrel at the start of 216 to US$ 48 at the end of September. Elsewhere, the business cycle for industrials also looks to be bottoming, albeit at different speeds by region. Total return (%) 15 1 6 4 Yield/spread (%) Figure 8: Changes in capex 45% 5 2 2 4 6 8 21 212 214 216 5-yr US Treasury Spreads Return (LHS) Source: Bloomberg, JPM, CEMBI Diversified Index, 3 September 216 Average rating is investment-grade It is a common misconception that companies in emerging markets are not as well-run as those in developed countries. On the contrary, the average rating of the EM corporates index (CEMBI Diversified) is an investment-grade rating of BBB-/Baa3. With investment-grade issuers making up 63% of the benchmark, the CEMBI Diversified 25% 5% -15% -35% 9 21 211 212 213 214 215 Emerging Europe Middle East & Africa Asia Latin America Source: JPMorgan, August 216 4
Meanwhile, EM default rates have risen since 211 but only modestly and they remain below their long-term average. For 216, they are expected to reach 5.5%, compared to a forecasted 6% for US high yield. Most defaults have already occurred and we expect an improving default outlook in 217. Figure 9: Default rates EM vs. US high yield 2% 15% 1% 5% % 2 4 6 8 21 212 214 216F EM Corporate HY US HY Source: JPMorgan, August 216 Latin America has seen the biggest percentage of defaults this year so far at 6.5%, followed by the Middle East and Africa at 3.1% and Europe at 2.9%. Asia has been the strongest region with.9% of defaults. Supportive technicals Bond supply dynamics have become increasingly positive in the past year as new issues dwindle, creating scarcity value. After reaching a record level of US$ 372 billion in 214, EM corporate bond supply slowed in 215 as Brazil and Russia were effectively shut out of international bond markets. Russia faced international sanctions for its annexation of Crimea, while Brazil grappled with a corruption probe at state-owned oil company Petrobras. So far this year, gross bond supply has remained relatively low and is roughly at the same level as in 215. One reason is because Chinese issuers are converting their dollar debt to onshore yuan funding. We expect net US dollar bond issuance to be subdued as well, as much of the year s low issuance is being used for refinancing and extensions. This has lowered near-term default risks for many credits, which has in turn improved the credit outlook and lowered spreads. 5
Figure 1: Supply has slowed in 215 and 216 USD billion 4 3 1 Jan Feb Mar Apr May Jun Jul Aug Sep Okt Nov Dec 212 213 214 215 216 Source: JPMorgan, 3 September 216 Valuations EM bond valuations are fair compared to historical levels. The current spread-to-worst level of 32 bps is close to its 1-year average. Given the increasing resilience of emerging markets, we think that these current spread levels are reasonable. Figure 11: EM corporate debt spread levels 1 8 techniques allows us to monitor and analyse risks from a portfolio perspective. Our investment approach, which we view as our distinguishing edge, does not change. We maintain a structured, consistent and disciplined approach to managing the strategy. Diverse, experienced team An additional strength, which we believe adds to our likelihood of generating positive results, is the diversity of our EM corporate debt team as it helps bringing different points of view to bear on the markets. Team members have different professional backgrounds (sell-side analyst, buy-side analyst, rating agency credit research analyst, risk manager, etc.) and personal backgrounds (team members come from emerging countries and regions such as Russia, Peru, Asia etc. and all speak at least two languages). Global resources NN IP s EM corporate debt team, which is part of the EMD team, is autonomous and responsible for every decision across the strategies it manages. Nonetheless, it has access to NN IP s network of investment professionals. The investment professionals share their individual knowledge to enhance the collective insights that contribute to the decision-making processes. Our global footprint enables a deep understanding of local markets, industries, and regulatory dynamics. For example, investment analysts constantly have discussions with the EM sovereign debt team, which enhances issuer level analysis by understanding the country environment. basis points 6 4 Investment insight gained at a local level and shared globally maximises investment opportunities for our clients. Our investment platform promotes knowledge sharing across the firm. Oct 6 Dec 7 Feb 9 April 1 Jun 11 Aug 12 Oct 13 Dec 14 Feb 16 Spread to worst Average Z-spread to Worst since 6 Source: JPMorgan, CEMBI Diversified Index, 3 September 216 3. Why NN Investment Partners Investment edge We believe that EM corporate debt is still an evolving asset class, therefore market inefficiencies exist that can be exploited. As such, active management should deliver the most attractive results. We believe that our investment edge in the EM corporate debt strategy lies in the following elements: Investment approach and risk management Our investment approach is based on taking a large number of imperfectly correlated risks across countries, sectors and securities. This is likely to result in a higher Information Ratio than markettiming or beta risk. We attempt to minimise specific event risks by applying single-region, single-country, issuer and issue limits, with the belief that our approach to diversify risks leads to better riskadjusted returns. Our experience with advanced risk management Performance of NN (L) Emerging Markets Corporate Debt This philosophy and process have allowed for a competitive performance of the NN (L) Emerging Markets Corporate Debt fund relative to its benchmark since inception (see graph). Figure 12: Performance of the fund vs. benchmark 4% 3% 2% 1% % -1% 211 212 213 214 215 216 NN (L) EM Corporate Debt Benchmark Source: NN IP, September 216. Illustrated are the performances of NN (L) Emerging Markets Corporate Debt (I Cap USD, inception date 6 July 211) and the JP Morgan CEMBI Diversified Index. 6
For an investment manager to be successful in this space, research is critical. Although they have improved significantly in recent years, emerging markets are still far less mature than developed ones meaning that corporate information may be more difficult to access, disclosure may vary in terms of quality and volume, and country, political and corporate governance factors play a significant role. A manager with a strong track record of investing in EM corporates and a deep understanding of the individual economic regimes would be at an advantage. Furthermore, a manager with a strong local presence across multiple jurisdictions will be best positioned to develop the information advantages that lead to alpha generation. NN Investment Partners is a pioneer in the EMD strategies with one of the longest track records in the industry, going back to almost the inception of the asset class in 1993 (for EMD hard currency) and 1998 (for EMD local currency). We have been managing dedicated EM corporate debt assets since 3 and opportunistically since 1993. Our managers and analysts cover markets based in the three major time zones: Europe, Middle East & Africa (EMEA) is covered out of The Hague, Latin America is covered out of New York and Asia is covered out of Singapore. 7
Disclaimer The elements contained in this document have been prepared solely for promotional purposes and do not constitute an offer, in particular a prospectus or any invitation to treat, buy or sell any security or to participate in any trading strategy. This document is intended only for MiFID professional investors. While particular attention has been paid to the contents of this document, no guarantee, warranty or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change or update without notice. Neither NN Investment Partners B.V., NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group, nor any of its officers, directors or employees can be held directly or indirectly liable or responsible with respect to the information and/or recommendations of any kind expressed herein. The information contained in this document cannot be understood as provision of investment services. If you wish to obtain investment services please contact our office for advice. Use of the information contained in this document is solely at your risk. Investment sustains risk. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such. This document and information contained herein must not be copied, reproduced, distributed or passed to any person at any time without our prior written consent. This document is not intended and may not be used to solicit sales of investments or subscription of securities in countries where this is prohibited by the relevant authorities or legislation. NN (L) Emerging Markets Corporate Debt is a subfund of NN (L), established in Luxembourg. NN (L) is duly authorised by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Both funds are registered with the CSSF. For more detailed information about the investment fund we refer to the prospectus and the corresponding supplements. In relation to the investment fund mentioned in this document a Key Investor Information Document (KIID) has been published containing all necessary information about the product, the costs and the risks which may occur. Do not take unnecessary risk. Read the prospectus and the KIID before investing. Investments are accompanied by risks. The value of your investments depends in part upon developments on the financial markets. In addition, each fund has its own specific risks. See the prospectus for fund-specific costs and risks. The prospectus, supplement and the Key Investor Information Document are available on the following website: www.nnip.com. This document is not directed at, and must not be acted upon by citizens of the United States (US) and is otherwise only directed at persons residing in jurisdictions where the relevant share classes/(sub)funds are authorised for distribution or where no such authorisation is required. Any claims arising out of or in connection with the terms and conditions of this disclaimer are governed by Dutch law. Costs are associated with investment. The management fee of this fund amounts to.72% per annum for the I Cap USD share class. 8