Emerging market debt (EMD) is a very large and diversified asset class. A cohort of nearly 800 issuers represent a market of nearly $2 trillion – in other words, a market that is 20% larger than U.S. High Yield, with strong credit fundamentals to go along with its size and potential.
In this interview, Sanjay Yodh, Director US Insurance, and Karen Bater, Senior Fixed Income Specialist, talk about why many insurers are showing increased interest in EM corporates.
Why is EM corporate debt of particular interest to insurers at the moment?
Yodh: Insurance companies tend to allocate to EM debt on the surplus side of their balance sheets. They are generally trying to create some additional diversification while potentially outperforming the US investment grade and High Yield credit markets, two asset classes where they tend to have strategic allocations. Whether they are total return or yield focused, more than half of the conversations we’ve had with insurance companies have included some variation of these two questions: We’re not invested in emerging market debt, should we be? Or: We are invested in EMD, should we be investing more?
Bater: Valuations have significantly improved in emerging market debt, compared to the beginning of the year. We’ve seen tremendous spread convergence between US High Yield and EM corporates, and that makes the emerging market corporate universe look a lot more attractive. EM corporate debt is a large and diverse $2 trillion universe, with around $1 trillion of quasi-sovereigns – they’re generally structurally important to the EMD sovereign, so the default rate is a lot less.
Q: What about the credit quality of EM debt?
Bater: EM corporates offer more diversification possibilities and have both investment grade and high yield issuance, potentially providing better risk-adjusted return opportunities. The general EM corporate bond universe has a BBB- credit quality relative to US High Yield, which is B or B+. At the moment, EM corporates are delivering similar yields with a much lower default rate and similar recovery rates as compared with US High Yield.
Yodh: The credit quality of EM corporates is a big deal for insurers from a regulatory and NAIC perspective. Some in the US insurance industry may not be fully aware that that is the case.
Q: What role do US monetary policy and interest rates play in the EM corporate debt story?
Bater: Given the amount of exposure that insurance companies have to the debt space, a strategic allocation to emerging market debt makes a lot of sense. The biggest concern right now for the skeptics on emerging market debt and other risk-based asset classes is that the potential damage from higher US interest rates and a strong dollar could hurt the financing in developing countries. However, as long as the fed is tightening monetary policy in response to faster economic growth, some of the emerging market corporates should be relatively positive. If you look at EM corporates and their history, they have long experience with multiple currencies. They are very adept in managing businesses around these currencies. For example, in 2015 when commodity prices declined, a large proportion of EM debt issuers are large exporters that earn substantial US dollar-based revenues. They may have had depreciating currencies they were paying people with locally, but maybe earning revenues externally. In cases such as those, the credits are generally better, with higher yield, less leverage, and greater spread than their similarly rated US counterparts.
Q: Some investors worry about EM corporate defaults. Should they?
Bater: EM corporate default rates have averaged around 1.5 percent since 2000, while US High Yield is somewhere around 4% over the same time period. If you have an asset manager who’s doing good bottom up work, you could benefit from buying companies who are seizing the opportunity in a faster economic growth environment and growing their business and their top line, and that don’t have a lot of debt. Generally, they have a shorter duration and higher yield than US investment grade. They also tend to have higher credit quality and better spread per turn of leverage in almost every rating category.
Q: What’s the best way for insurers to access EM debt?
Yodh: US insurance companies tend to be very US-focused because their liabilities are originated domestically, and because the market is mature they might think they can accomplish everything they want from an investment perspective in the US. But the world is a big place, and the opportunity set is bigger and more accessible today than ever before. To ignore such a large market, you’re ignoring a significant opportunity to generate returns, and to take advantage of a faster-growing, more accelerating environment. The best way to access this asset class is to have a pretty robust capability in this space, which means you need resources on the ground in order to really take advantage of the inefficiencies in these markets. Having offices in nearly 50 countries and a large team focused on emerging markets, we have the resources to do the research both on the EM corporate and sovereign side to help insurers identify the risks and opportunities inherent in the asset class.
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