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High potential for a catch-up - emerging market corporate bonds

by Thomas Rutz

The coronavirus pandemic has also resulted in significant challenges for the economies of emerging markets. However, their economic recovery and therefore the ‘catch-up’ potential of corporate bonds from this segment should not be underestimated.

Although the global financial markets fell by 10 - 20% across the board with the outbreak of the coronavirus in March, most asset classes have already returned to positive territory year-on-year and some are even posting record highs. The S&P 500 Index, for example, was trading at close to 10% year-on-year at the end of October 2020, while in the bond market, the Barclays Global Aggregate Total Return Index is trading at an annual return of almost 6% and the J.P. Morgan Corporate EMBI Broad Diversified Index is sitting at 4%. This rapid recovery was driven in particular by the significant increase in liquidity as a result of the extensive monetary and fiscal support measures implemented by governments and central banks. The performance of high-yield corporate bonds from emerging markets is slightly above 2% year-on-year (J.P. Morgan Corporate EMBI Broad Diversified High Yield Index). Although this is also a good performance, it is lower than that of the other asset classes. Nevertheless, these securities are not necessarily in a worse position than those of other markets.

Emerging markets: crisis-tested and flexible

In comparison with their counterparts in the developed industrial countries, companies from emerging markets are relatively experienced in dealing with recessions and political escalations and are therefore more crisis-tested. Many emerging market companies acted promptly and adapted quickly and effectively to the new reality with cost-cutting programmes, generating liquidity, etc. For example, Unigel, a Brazilian petrochemical producer, suffered a 60% year-on-year decline in EBITDA in the second quarter of 2020, but was able to maintain its cash position by prioritising working capital management (including closing three plants and switching from local to international suppliers due to better payment terms). As a result, analysts have already lowered estimates of default rates in the high-yield segment for 2020 from an initial 4.8% to 3.5% (J.P. Morgan). For the US counterpart, however, a default rate of 6.5 % (J.P. Morgan) is expected this year. In addition, due to a lack of investor interest and insufficient liquidity, companies that were fundamentally in a very good position and were only marginally affected by the pandemic were penalised. This also offered attractive entry opportunities for investors.

Positive economic development expected

While economists expect global economic growth to contract by 4 - 5% in 2020, the estimate for emerging markets is lower at 3%. A significant recovery of around 6% is even expected in 2021. Export volumes from emerging markets have already returned to levels similar to those before the pandemic. Price developments on the commodities markets are also positive. Not only precious metals, but also many base metals (copper, iron ore, etc.) and agricultural products (soybeans, protein) are currently trading at a multi-year high. For many emerging markets, commodity exports continue to be important growth drivers. In 2019, for example, two-thirds of all Brazilian exports consisted of commodities. The positive price momentum will be felt throughout the entire value chain, and GDP growth is likely to deliver a positive surprise. The oil market should also continue to recover in 2021. With the current oil prices of just over USD 40 per barrel, supply remains relatively limited, as it is not worthwhile for many US fracking companies to ramp up production again at these prices. According to Baker Hughes, as a result, the number of active US drilling rigs fell from 680 in March 2020 to currently around 200.

Good prospects thanks to a range of performance drivers

The approval of a vaccine against coronavirus and a more moderate US foreign trade policy under a Biden presidency could weaken the US dollar over the long term. This would further boost investments in emerging markets. A steeper yield curve over the medium term as the economy recovers should also increase investors' risk appetite and provide a boost to the asset class.

Overall, the outlook for emerging market bonds is therefore positive and a further ‘catch-up’ to other asset classes can be expected in the medium term. High-yield emerging market corporate bonds in particular currently offer an attractive risk-return profile for investors looking for additional returns, and further inflows into the asset class may continue to drive the recovery.

Author: Thomas Rutz, Portfolio Manager of MainFirst Emerging Markets Corporate Bond Fund Balanced and MainFirst Emerging Markets Credit Opportunities Fund

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