Emerging market businesses are not sated by bond issuance and this creates an opportunity for private debt investors, says David Creighton of Cordiant.
The massive growth in emerging market corporate bond issuance has coincided so neatly with a more than 30% fall in bank lending to the emerging markets* that some commentators seem to think that the bond market has simply replaced bank lending. In our experience, this is far from the truth: a broad range of substantial businesses in the emerging markets are simply not able to participate in the bond market because of their size or specific requirements. This has created a lending gap into which private debt investors can step.
There are several key factors that make a compelling case that emerging market private debt investment currently offers a better risk/reward profile than emerging market bonds:
- a relative lack of competition in the loan market presents opportunities for higher spreads for investors;
- the structure of private debt deals allows lenders greater scope for managing risk than through investments in bonds;
- the variety of deals available allows greater diversification than the bond market.
The past year has been marked by falling yields on emerging market bonds – the consequence of the great influx of money into the asset as investors search for more attractive yields than can be found in the US treasuries, gilts and bonds. With the bond market overheated, the current climate presents an especially good opportunity to invest in emerging market private debt, with more attractive yields on offer than can be achieved by many other debt asset classes.
For a variety of reasons, international banks have cut back their lending in the emerging markets. However, continued economic growth means the demand for funding is increasing and it is doing so at a level which the local banks are not able to satisfy.
Strong demand and a slackening of competition between potential lenders has led to a spread on emerging market private loans that has significantly increased since the credit crunch, with investors benefitting from spreads around 200 basis points higher than in 2008.
If deals are properly structured, these yields can be achieved with considerably less risk than is associated with emerging market corporate bonds.
Private debt deals can give the lender seniority within the credit structure ahead of bondholders. The investor can choose deals where, in the case of default, the debt is secured against high quality collateral. Lenders can also pick loans, such as infrastructure investments, where they have a high level of oversight of how that money is used. Loans can be drawn down in stages only as milestones are hit. Within emerging market debt, that greater control and oversight is valuable.
The floating rate interest payments, written into most emerging market loans, reduces duration and helps to mitigate interest rate risk for the lender.
The more limited liquidity of private debt versus publicly traded bonds can be perceived as a disadvantage for investors who have a short term investment horizon. While a modest secondary market for private debt does exist, investors in private debt should see this class as a buy and hold investment.
Some would argue that the relative illiquidity of the private debt market can be a blessing in disguise. It is the large flows of funds into emerging market bonds that have driven their yields down so low. Rapid flows of hot money out of emerging market bonds would see their prices fall. Private debt manages to avoid that kind of price volatility though, admittedly, by sacrificing liquidity.
Another attribute that attracts investors to emerging market debt is portfolio diversification. Investors in emerging markets are not just interested in the faster growth and more favourable demographics of the emerging markets versus the West; they also expect that the returns from their emerging market investments will be relatively uncorrelated from returns in Western markets.
What many do not realise is that private loans in emerging markets see greater diversification than the emerging market bond universe. International investors are focused on a narrow set of emerging market bonds, in restricted geographies and sectors. Particular favourites are the Bric nations – predominantly Brazil, Russia and China – and the resource, energy and telecom sectors. Risks are concentrated.
The result is a bond portfolio that does not provide all the risk diversification that its investors are seeking, and also overlooks potentially interesting credit opportunities in other sectors.
Emerging market private debt funds have a much broader scope that includes a wider range of industrial sectors and utilities as well as consumer-led sectors, such as food and retail, where growth is driven by rising incomes and favourable demographics. The geographical reach is broader too, with deals in stable but fast-growing economies across Asia and Latin America, and select deals with the most robust credit in Africa.
The advantages of better yields, better risk control and better diversification suggest that investors looking to the emerging markets to generate stronger income would do well to look at private debt where growth opportunities are being created across a range of countries and sectors that are not being served by local banks or the global bond markets.
* Bank for International Settlements data shows syndicated lending to emerging markets fell from $353 billion in the year to September 30, 2011, to $245 billion in the year to September 30, 2012.
David Creighton is president and chief executive at Cordiant
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