Eyes on the yield in emerging markets corporates
admin | November 20, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
With many investors looking for yield somewhere in the constellation of debt markets, the yield in emerging markets corporate debt should draw attention in 2021. Emerging markets US dollar corporates offer much wider spreads to both US investment grade and high yield. A handful of opportunities are already in the market. And the opportunities come against a background of steady if uneven economic recovery from pandemic.
Incremental yield to US credit
EM corporate debt still offers incremental yield and spread to US credit. The JPM EM Corporate Bond Index—CEMBI Broad, including both corporate investment grade and high yield issuers—has a spread-to-worst of 300 bp over the US Treasury curve and a yield-to-worse of 3.77%. The JPMorgan EMBI Global index, including sovereign issuers only, has a STW of 377 bp as of mid-November and a YTW of 4.79%. In addition, CEMBIG at 300 bp, is still far away from all-time lows of 157 bp.
Incremental yield to US investment grade
EM corporate IG offers an attractive pick-up to US IG. The JPMorgan CEMBI Broad IG index (Baa2/BBB-) at a STW of 185 bp and YTW of 2.7% offers a pick-up of 76 bp to the Barclays US Corporate Aggregate index, which has a YTW of 1.9% and OAS of 109 bp. Within EM, from a relative value perspective, CEMBI Latin America IG has the biggest pick-up to US HG at 81 bp, followed by EM Europe 64 bp, while Asia IG at 21 bp looks less attractive relative to US compared to Asia HY.
Incremental yield to US high yield
EM corporate high yield also offers incremental spread, though investors need to be selective across regions and credits. EM high yield should perform well based on EM and developed market expected economic rebound in 2021 driven by consumer demand in BRICs and the implementation of a Covid-19 vaccine. The regions that offer more yield are Asia followed by Latin America. In Latin America, various sectors could still outperform including financials, transportation, infrastructure and consumer. Oil and gas state-owned credits look more challenged as risk mixes oil volatility, levered balance sheets, and weakness of sovereigns that own the national oil companies.
Opportunistic trade ideas in Latin America corporates
AESGEN 6.35% 2079 (callable in 2025) YTC 5.25% Jr Sub (Ba2/BB). AES Gener (Baa3/BBB-) is AES Corp’s subsidiary in South America with core operations in Chile (A+/A-) and Colombia. AES Gener has a net leverage of 3.4x, a solid cash position of $1 billion and a soft amortization schedule. Company it is growing its green portfolio in Chile and divesting from coal assets. Existing bond pays a premium over most other utilities in the same ZIP code (200 bp to 300 bp) due to subordination, lower rating and expectations around reset date. A YTC of 5.25% it is a reasonable proposal for a defensive 4.5-year paper with a committed and global energy shareholder (AES) with reasonable expectations to be called on 04/2025 when rate resets to UST5 year. + 4.91%.
One way to play a Mexican recovery in 2021 is through Banorte Tier II perpetuals, offering 4- to 10-year tenors if called at reset dates (currently trading to call) with YTC from 5.5% to 6.6%. Banorte is an IG issuer (Baa1/BBB-) while Jr. subordinated paper is BB-/Ba2. The bank has ample liquidity, is well funded and capitalized, as such, there are reasonable expectations for bonds to be called at reset/call date, as bank wants to keep the doors open for further issuance. Banorte is the second largest bank in Mexico by assets ($81 billion). As the US economy rebounds the Mexican economy should follow (expected GDP Growth Mexico in 2021 +3.5% based on Bloomberg), benefiting the consumer and banking sector which are deeply ingrained. Banorte has solid metrics as of 3Q20 with a market cap of $15.5 billion, revenues of $7 billion and net income of $1.6 billion. It has a solid capitalization ratio of 21.1% (Tier 2 – 13.7%), ROEs of 16.9%, declining NPLs of 0.8%, total loans of $38 billion, NIMs of 5.8% and has a provision of 265% of NPLs.
Brazil’s economic recovery story is already reflected on much better third quarter 2020 earnings across sectors, with GDP 2021E +3.5% (Bloomberg average). As the economy grows in 2021, banks and consumer companies like Cosan (CZZ 5.5% 2029), Rumo and Braskem will benefit. In addition, commodity players levered to Asia’s growth like Vale, CSN, Suzano will benefit from a commodities pricing boom while accessing to cheap financing in Brazil and overseas, posing potential spread compression as more funds enter the asset class in the search of yield.
Wide spreads against a background of rebounding growth
The opportunities in emerging markets corporate debt come as economic recovery in the second half of 2020 has been steady if uneven, varying across country and region. Asia has led, driven by China. EM recovery has been driven mainly by a handful of factors:
- A pick-up in consumer activity in the largest economies during the second half of 2020
- China’s early response to pandemic and economic it’s rebound in 2020 and 2021, with the Bloomberg average 2021 GDP forecast for China at 8.1%
- A pick-up in commodity prices after the second quarter of 2020, driven by strong Chinese demand for iron ore, copper, natural gas and agriculture
- Expansive fiscal policy by local governments and accommodative monetary policy by global central banks, and
- A US trade deficit and US dollar weakness
The recovery has been reflected in a healthy rebound in corporate earnings across EM during the third quarter of 2020 in tandem with a rally in EM asset prices. Since the March lows, EM benchmarks have performed as follows: MSCI EM +58%, EMBI spreads tightened from 650 bp to 350 bp, equity indexes Bovespa +68%, Mexbol +27%, Shenzhen +40%.
EM corporates has become a more mature asset class with a total USD size of $2.5 trillion. The EM primary issuance market has been very active with total corporate issuance of $451 billion YTD of which Asia is 64%, CEEMEA 21% and Latin America 15%, according to Bond Radar. . In 2021, EM corporate issuance is estimated to surpass that number. Bond refinancing, redemptions and net new issuance should make 2021 a very active year in EM credit.
After a challenging second quarter of 2020, EM debt outflows reverted. However, despite EM corporate debt becoming a more mature asset class it is still a volatile one, driven by yearly and sometimes quarterly changes in fund inflows and outflows dynamics in both debt and equities, affecting the different EM debt sub-asset classes: hard currency, local currency and blended. Still, EM is expected to continue to attract assets.
Sovereign risk matters creating dislocations between sovereigns and corporates, strong companies in smaller and weaker or stressed jurisdictions trade at a premium for example in Central America. This dynamic creates asymmetric risk/reward opportunities in less known or traded corporates with strong balance sheets and a dominant position in their markets (i.e.: utilities, banks) offering high single digit or low double digits yields, usually above the embattled sovereigns.
EM corporates still offer an attractive entry point, with Asia high yield and Latin America high yield and investment grade as the most attractive regions and sub-sectors to play from a relative value basis. Credit and country differentiation will be key in portfolio construction while the primary market will be very active in 2021.