Spreading for Spread: EM Long/Short Corporate Debt

Happy New Year, as happiness abounds in global markets unabated. Killjoys we are not and gladly defer to the multitude of market pundits whose market prognosis punctuated with risks have been sitting in many an inbox for the last few months. But as researchers and investors, prudence dictates that we tailor our responses in the face of all round euphoria that envelopes global markets today. Nowhere are exalted spirts more evident than in emerging markets (sorry for overlooking the crypto-mania) where both equity and fixed income markets continue to attract animated investors.

Focusing on fixed income for the purposes of our discussion here, it is evident that yield chasing behavior of investors (including passive driven retail), as manifested in local investors (especially in Asia), cross-over buyers (non-EM focused investors especially from Europe afflicted with negative yields) and yield-starved US investors, has seen them pile into all facets of liquid EM credit-local and hard currency sovereigns/quasi sovereigns and hard currency corporates. Despite record issuance, spreads have tightened all round most conspicuously in EM corporate high yields making their investment grade corporates and sovereign brethren look relatively less rich. While overall fundamentals remain supportive of EM, it’s probably timely to move on from a pure beta trade betting on spread tightening from flows to an active (alpha proposition) search for spreads as markets get more nuanced going forward.

Probably all EM debt investors recognize the make-up of EM fixed income and the underlying demand-supply dynamics besides regional nuances. A $3 trillion hard currency (G3) market comprising sovereigns, quasi-sovereigns and corporates is split almost equally across Asia (ex. Japan and Australia), Central Eastern Europe Middle East Africa (CEEMEA comprising over 60 countries but key issuers from a dozen countries) and LATAM. Enhancing the opportunity set are local currency bond markets that are ~14x G3 Asian markets and ~2.5-3x G3 CEEMEA and LATAM (markets not considering bank loans) enjoying a natural local bid most of the times. However, beneath the surface, Asian G3 markets are 90% corporates that also make up two-thirds of LATAM and half of CEEMEA G3 markets. Thus, corporates afford a larger (2x sovereigns) $2 trillion opportunity set (probably a little under accounting for liquidity).

All markets are dominated by investment grade (IG) non-financial corporate quasi issuers with Asia, given its breadth, includes other investment grade financials, and corporates that in aggregate outsize its high yield (HY) market. Though Asian HY is the largest in EM, LATAM and Central and Eastern Europe have printed more high yield paper as a percentage of their overall issuance in the last 4 years, in a conducive environment for lower rated companies to follow the gush of money. Despite easy conditions, most issuance is still for tenors 5 yrs. and under (though at the other extreme a little pick up in Additional Tier 1 (AT1)/perpetuals is also evident) to meet corporate growth and refinancing needs. Financials remain the most predominant issuers with real estate, TMT and utilities dotting the landscape in Asia and oil & gas in Emerging Europe and LATAM.

IG spreads across EM corporates have ranged 80-100 bps above US equivalents with CEEMEA affording even higher spread differentials in normal markets. Compared to their respective sovereigns, the spreads are typically 100-140bps higher. Higher spreads can digest the looming threat of gradual repricing of US treasury yields (rumblings of which can be heard over the last few days) with spread compressions offsetting higher US rates. While one may suspect reasons for these spread differentials, suffice it to say that EM IG and HY corporates are comparable to US equivalents on net debt/EBITDA, interest cover (EBITDA/Interest) and historical default rates (3.5-4% now trending lower to 2-2.5%).

Though the above reality is probably not hidden from all EM debt investors, the truth is that corporate issuance sizes (compared to sovereigns) are relatively smaller, the universe reduced due to liquidity and therefore less-trafficked by the large global debt managers. This increases the propensity for mispricing and invites regional alternative debt investors. Employing labor-intensive credit selection skills to distinguish issuers (on integrity, financial soundness etc.), regional alt. debt investors closely monitor serial borrowers among other corporate issuers to identify mispricings of securities for both the long and short sides of their portfolios, yet again differentiating themselves from large global debt managers.  Nimble trading with smaller balance sheets is paramount to capturing good entry points afforded by normal volatility (a rarity in recent times). When spreads are overly tight or a new issue priced too tightly, it also affords good shorting opportunities outside the purview of benchmark (or even unconstrained) oriented traditional investors. To add, over 30% of global EM corporate issuance-IG and HY- is outside the conventional (CEMBI) and other (JACI etc.) indicies which is most prominent in Asia followed by LATAM and CEEMEA thus offering a more expansive opportunity set for alternative debt investors. Higher yielding (100-150 bps over issuers’ secured bonds) AT1 paper from top tier banks adds to the mix. Liquidity is key as also access to inventory which calls for a diverse network of local trading counter-parties. Last but not least, is their ability to hedge out interest rate risk and also currency risk if they straddle into local currency corporate bonds, a restricted (limited access) preserve for only a few.

Recently when EM IG Corp spreads have tightened to 40-50 bps over US equivalents and EM HY Corp ranged -20 to -70 bps against US HY, there is a greater emphasis on “better entry points/buy the dips” suggesting managers are positioned with dry powder (and lower gross exposures) to take advantage of any small market disruptions that have historically seen IG spread differentials widen ~25 bps with HY dislocating even more. The advantage could be both in terms of capturing a higher current yield as well as capital appreciation from repricing of risk. While there are lower vulnerabilities (better current accounts), to avoid Taper Tantrum 2.0, and a GFC is unfathomable by and large, there are a mix of global and local factors that might spoil the beta rally despite the continued lunge for yield. The pace of climb for US treasuries for one or more reasons (Fed hikes, lower overseas demand for US treasuries etc.) and a strengthening dollar are oft cited as potential reasons for reverse EM flows as much as unknown consequences of unprecedented gradual withdrawal of stimulus by other central banks following the Fed. China’s economic rebalancing slowing import demand and industrial capacity cuts, could also have ripple effects in the region. While local investors especially in Asia and cross-over buyers should continue to lap up any new supply from the ~$175 billion (per JP Morgan) of EM bond refinancings in the near term, any tempering of demand due to rising yields could create stresses for issuers affording attractive buying opportunities. Foreign holdings of local currency bonds (in the absence of local institutional support from pensions) and large fiscal imbalances (loss of oil revenues) still prevail in some of LATAM and CEEMEA that present some fragility. Above all, politics (e.g. NAFTA negotiations for Mexico) remains the biggest wildcard with the 2018 EM political calendar by far the most hectic in recent memory with six elections planned for Asia, eight for LATAM and eleven for CEEMEA. Besides these impending concerns, each region is on a different growth trajectory and needs to be appreciated for its own rate cycle e.g. Asia mostly inflating, LATAM (Brazil, Mexico, Argentina) disinflating with CEEMEA presenting a bifurcated (CEE inflating, Russia and MEA disinflating) picture. A confluence of factors as above, otherwise deemed risks for most traditional investors, presents an interesting playbook for EM alts. debt investors.

When (not if) the tide turns with any of the aforementioned risks materializing, technical support (e.g. hunt for higher real yields, China attracting more foreign investors/indexers to its inter-bank bond market through the Bond Connect) alone might be challenged to sustain the current rally. It’ll warrant not only a hedged approach to EM debt (especially corporate debt) but also an ability to benefit from any intermittent spread widening with rising (or fleeting) volatility, on both the long and short sides, a different place from traditional investing. If investors commit to the opportunity with patient, longer lock-up capital, it also makes a good recipe for a stressed/distressed play allowing time for spread compression or some form of corporate restructuring, yet again outside the purview of traditional EM debt investors. Therefore, it’s probably timely to seriously consider a long/short play in regional EM Debt markets to capture the bigger and growing opportunity set in EM Corporate Debt and any potential market dislocations. While our recently introduced tax reforms reduce incentives (e.g. corporate tax rate cut, interest deductibility, repatriation of overseas cash) for corporations to issue new debt thus reducing supplies from an already shrinking corporate debt market (especially HY with migration to leveraged/cov-lite loans), EM is likely to see increased issuance of corporate paper (3x gross sovereign debt) in lock-step with growth/capex/refi. needs.  As mentioned above, EM corporate debt inherently affords higher spreads to DM equivalents and EM sovereigns without compromising on quality, and spreads get only wider when (not if) volatility picks up affording good entry points. Shouldn’t that sustain our happiness?

ÊMA continues to remain responsive to investors’ continued search for return premiums and is actively spreading across EM in search of spreads conducting independent investment audit on regional EM alternative debt specialists for the benefit of LPs.  Stay tuned.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

January 11, 2018

The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.