Insight

Emerging market corporates: Identifying opportunities in a stressed price environment

Emerging market corporates: Identifying opportunities in a stressed price environment

Invesco Fixed Income thinks that coronavirus-related volatility has led to once-in-a-decade investment opportunities in emerging market corporate bonds. In this article, the team identifies companies that will best weather current conditions.

Impact of pandemic on global demand and supply chains

With nearly half the world’s population in lockdown, global demand and supply chains have been severely impacted by the coronavirus pandemic. The most affected sectors include the energy sector, especially upstream exploration and production (E&P) companies amid the recent collapse in oil prices, transportation, with its grounded fleets of planes, discretionary consumer goods, automakers and basic materials, among others. Some sectors have been more resilient, such as utilities, pulp and paper, technology and media and telecommunications.

Global policy support

Global economic deterioration has been slowed by extraordinary fiscal and monetary policies put in place by governments and central banks around the world. The US has implemented a USD2 trillion stimulus package and recently the US Senate approved an additional stimulus bill worth USD484 billion to help consumers and impacted industries navigate this crisis.1 The US Federal Reserve has announced extensive measures, including the purchase of at least USD500 billion of US Treasury securities, USD200 billion of mortgage-backed securities, new financing of up to USD300 billion to support employers, consumers, and businesses and three new lending facilities to support consumer and credit markets.2 Similar measures have been implemented in other developed and emerging markets (EM).

EM corporates relatively well-positioned to weather coronavirus disruption

We believe EM companies are relatively well positioned to weather the global downturn. The annual EM high yield default rate was only 0.3% for the year ending in March, versus 2.7% in the US.3  At the same time, EM net financing requirements (debt issuance minus debt repayments), were expected to decline from USD112 billion in 2019 to USD5 billion in 2020, helped by pre-financing activity during 2019.4  With Asian corporates accounting for 39% of the JP Morgan Corporate Emerging Markets Bond Index (CEMBI)5, a large portion of the index should be already benefiting from declining infection rates and economic recovery in Asia. In addition, sectors most at risk, such as transportation and E&Ps, account for only 0.8% and 1.2%, respectively, of the CEMBI. These issuers typically benefit from relatively solid short-term balance sheets which should allow EM high yield default rates to remain moderate versus US high yield.

Outlook for EM corporates supported by valuations

EM corporate bond valuations have cheapened dramatically amid broader volatility in global risk markets. The CEMBI spread widened by about 400 basis points in late March and today sits at around 550 basis points (Exhibit 1). The recent moves represent the second largest spread widening in 20 years, after the 2008 global financial crisis.6

Emerging market corporates: Identifying opportunities in a stressed price environment

We believe current valuations represent a “once in a decade” investment opportunity. Since its inception  in December 2001, the CEMBI has historically returned around 14% in excess of US Treasuries after reaching such cheap valuations (Exhibit 2). Exhibit 2 shows spread levels for the CEMBI versus the one-year forward excess return. As shown, the CEMBI has historically generated positive excess returns above 10% in the subsequent year after the spread has exceeded 450 basis points. Also shown, when the spread exceeded 450 basis points, the dispersion of excess returns was narrow, improving the level of confidence in strong returns compared to lower starting spread levels. This is largely due to a combination of strong carry, lower bond prices and recovering financial conditions within one year.

Emerging market corporates: Identifying opportunities in a stressed price environment

Invesco Fixed Income’s (IFI) EM corporate research team’s bottom-up analysis of individual issuers has identified the pulp and paper, consumer, infrastructure and metals and mining sectors as the most attractive based on our analysis of respective one-year default expectations. For example, in metals and mining and building materials, the supply chain disruption combined with low inventories could result in significant raw material shortages when economies emerge from lockdowns, potentially resulting in sharp commodity price appreciation and outperformance of these sectors.

Identifying potential investment opportunities

To identify individual investment opportunities, we seek corporate bonds of issuers with the strongest liquidity positions among the credits that have experienced the most spread widening. To determine how strong companies’ short-term balance sheets must be to withstand the current downturn, we make assumptions about how long current tight financial conditions are likely to prevail. The duration likely depends on two criteria: (a) the duration of the coronavirus health crisis and (b) the pace of economic recovery. Central banks and governments have accelerated policy support to limit the extent of economic damage and speed recovery. We conservatively assume 12 more months of tight financial conditions, during which access to capital markets will likely remain limited to many issuers. In this environment, we seek to identify companies with solid liquidity positions and the ability to successfully manage cash and operations while still being able to generate profits during this uncertain period. We focus on the following three metrics to indicate these credit strengths:

  • Liquidity in Excess of Short-Term Debt
    We favor companies with cash and marketable securities (high quality government bonds and bills) well in excess of short-term financial debt. The location of cash in a company’s capital structure is also critical since reported consolidated cash might not be fully available to service debtholders due to upstream dividend leakages, cash tied to specific projects or capital controls. Credit revolvers can also be considered if they are committed and the company is expected to remain in compliance with the revolver’s covenants. We avoid companies with a disproportionate amount of short-term debt relative to cash.
     
  • Solid Current Ratio
    We favor companies with short-term assets well in excess of short-term liabilities. For example, we seek enough working capital to cover salaries, administrative expenses and interest and maintenance expenditures if a company were to stop operating for a short period of time.
     
  • Cost Curve Leaders
    Last, we favor top-quartile cost leaders with healthy operating and free cash flows. We believe these companies will likely outlast other companies in their sectors and will likely attract a disproportionate share of global capital and investor support.

Conclusion

We believe the EM corporate bond universe currently offers “once in a decade” investment opportunities. Global central banks and governments have provided monumental support to ease economic damage caused by the coronavirus pandemic and valuations are at historically attractive levels, in our view. We believe IFI offers research capabilities and investment approaches to take advantage of this unique market opportunity. Through careful credit research and flexible investment approaches, we seek to maximize risk-adjusted returns as bond markets recover, while avoiding potential defaults.

Fabrice Pellous, CFA, is Senior Credit Analyst at Invesco Fixed Income. Peter Wietrak, CFA, is Senior Credit Analyst at Invesco Fixed Income.

^1 Source: US Department of the Treasury, April 22, 2020 (https://home.treasury.gov/policy-issues/cares).
^2 Source: US Federal Reserve, April 22, 2020 (https://www.federalreserve.gov/covid-19.htm).
^3 Source: BoAML, April 2020.
^4 Source: JPMorgan, Jan. 2020.
^5 Source: JPMorgan, April 22, 2020.
^6 Source: JPMorgan, CEMBI, Dec. 31, 2000 to April 22, 2020.