The gap in yields between emerging-markets U.S. dollar–denominated corporate bonds and their developed-markets counterparts remains high by historical standards, after the one-two punch of the Federal Reserve’s decision to taper quantitative easing, first announced a year ago, and internally driven political crises in several key markets, including Brazil, Russia and Turkey.
As a result, the spread between high-yield emerging-markets (EM) dollar corporates and developed-markets (DM) dollar corporates has risen to about 270 basis points — up from 120 basis points in early 2013, although the gap has narrowed slightly in recent months.
Investors acknowledge that continued Fed tapering is likely to cause further market turbulence as several emerging economies struggle to finance current-account deficits just as the wave of global liquidity is beginning to subside. Nevertheless, many of them say this gap has created an investment opportunity.
The current enthusiasm among some investors for EM dollar-denominated bonds is based partly on a belief in the benign effect of long-term structural factors and partly on a short-term view that the timing is good because bond prices have been beaten down. “From a valuation standpoint, emerging-markets dollar corporate debt looks very attractive if you think about the long-term environment,” says Robert Simpson, portfolio manager on the EM debt team at London-based Insight Investment, with $295 billion in assets under management. “U.S. pension funds and other investors face a shortage of dollar-denominated spread products. So over time, demand for dollar bonds — including emerging-markets corporate bonds — will remain very strong,” supporting the prices of EM dollar bonds, he adds.
“In periods of stress, emerging-markets dollar-denominated corporate bonds can be more volatile, because of the large number of off-benchmark investors who have a tendency to rush back into their home markets,” says Chris Kelly, emerging-markets debt analyst at BlackRock in London. “However, more and more institutional investors are dedicating long-term allocations to emerging-markets dollar corporates, so some of this money has become stickier.” Insurers in particular, he notes, are increasing allotments to this asset class from a low base.
The short-term case for EM dollar corporates hangs on pricing. “We definitely think this market is attractive based mainly on valuations,” says Jon Brager, senior credit analyst at £26.9 billion ($44.8 billion) Hermes Fund Managers in London, pointing to historical comparisons between the prices of developed- and emerging-markets corporates.
Taking the spread above U.S. Treasury yields for high-yield emerging-markets dollar bonds, at 627 basis points, and the spread above Treasuries for high-yield developed-markets dollar bonds, at 361 basis points, he calculates a ratio of 1.7. This compares with a typical ratio of 1 to 1.2 over the past 15 years. That ratio has been so high only three times recently, he says: at the height of fears earlier this year over the effects of tapering, when it peaked at 1.9; during the emerging-markets crisis that followed Argentina’s 2002 default; and during the 1998 Asian and Russian crises.
“Such a high ratio isn’t justified [now] because emerging markets are not in a state of crisis,” says Brager. He does believe, however, that for the bonds to be fairly valued the ratio should remain above the historical average, at about 1.4 or 1.5. Higher global interest rates, he says, will create economic and financial problems for some EM countries with large current-account deficits.
If institutional investors are convinced that value does indeed lie within emerging-markets dollar bonds, where should they head?
Some investors advocate Mexican securities. “We like Mexico because of its low current-account deficit — mainly based on stable foreign direct investment — and because of government reforms, which will boost the long-term growth rate, such as the opening of the energy sector to private competition,” says Simpson of Insight Investment.
BlackRock’s Kelly favors Grupo R, an energy services company that benefits from its “strong relationship” with Mexico’s state oil company, Petróleos Mexicanos, or Pemex. Grupo R’s double-B five-year bonds offer 6.3 percent.
If Mexico looks attractive in part because of its low and stable current-account deficit, should investors avoid countries with deficits that are either higher or less stable, or both? Brazil, India, Indonesia, South Africa and Turkey have recently been classed as the Fragile Five. But it might be time to rethink that grouping, says Kelly. “The Fragile Five has broken up and is now more like the Terrible Two: South Africa and Turkey,” he says, citing concrete moves by Brazil, India and Indonesia to reduce their respective current-account deficits. Even in those two countries, though, Kelly notes that there are “winners as well as losers.”
Investors warn, however, of the need to be aware of the risks involved when buying bonds of countries with potential currency problems. Simpson says that although investors going into dollar-denominated bonds don’t suffer directly from local-currency depreciation, the risk of default increases because of the burden of servicing the dollar debt through a currency that is seeing its value fall in dollar terms. This is a serious problem for Turkish banks, he notes, which have issued debt in dollars and must fund most of it through their home market. Simpson says that it is less of an issue for export-focused companies, by nature less reliant on local-currency income.
Exporters in countries with troubled currencies can be even more attractive for another reason: Currency weakness makes them more competitive. The recent depreciation of South Africa’s rand, for example, makes BlackRock’s Kelly favor the debt of exporters such as Johannesburg-based energy and chemicals company Sasol, whose eight-year bonds, rated Baa1/BBB-rated, yield 4.4 percent.