Companies in emerging markets are keen to borrow capital and while these economies continue to expand, investors are happy to supply it but, warns Esther Chan at Aberdeen Asset Management, they must do their homework.
The case for investing in emerging market corporate debt is becoming stronger by the day as the size and diversity of the market grows. With new net issuance of about $100bn (€71.1bn) a year, Esther Chan, portfolio manager on Aberdeen’s emerging market desk, is convinced the universe of investable bonds will exceed a trillion dollars in the next couple of years.
But investors would be wrong to think they can simply pump money into this asset class without carefully analysing which companies it is going to, and in which regions. There are different levels of corporate governance and also different structural considerations for bond issuers in Latin America and Asia, for instance. There are also political risks and differing standards of regulation to consider. However, these obstacles should not blind investors to the great opportunities, Chan says. “Emerging market corporates, historically, was off-benchmark for most people. Now it’s on-benchmark,” she says. “Liquidity has changed a lot.”
The market offers great promise because, in Chan’s view, emerging market (EM) bonds are still “mispriced”. Ratings agencies continue to give all companies in emerging markets a risk premium to account for country risk – the potential for political, regulatory or capital controls to affect investments.
But the consequence is that many companies receive a rating that fails to reflect the strength of their underlying business.
“For the same rating bucket, emerging market corporates always have better leverage ratios, better fundamentals,” she says.
There are also opportunities for investors willing to take a bullish position. This is becoming more popular as growth stalls in developed economies. “Is a company operating in the US really better than one operating in a fast-growth, credit-supportive, infrastructure-deficient country like Brazil? There is still bias against emerging markets,” she says.
Chan’s comments underline the point that investing in different regions requires a different approach. “There are a lot of common issues. But you have to understand the quirks of each region and how each one trades. We look at the fundamentals, and it’s more qualitative than in developed markets.”
“Asia tends to be very trading oriented, very driven by trading accounts – a lot of hedge funds. Latin America is more defensive.”
The qualitative point is important because, in Chan’s view, the character of the individuals running companies in emerging markets matters more than in developed countries. She says it is important not to look merely at the numbers, but at the people behind the numbers: the management and shareholders.
This kind of in-depth research requires many hours of analyst time, and Aberdeen’s fixed-income team constantly shares information. This data flows between the bond and equity teams, as many EM equity specialists do their own research into companies issuing bonds.
“Aberdeen is a credit intensive house; it’s all about understanding the risk characteristics of the country, the industry, the company, and its bonds, and picking the right bonds based on our own proprietary research,” she says.
This focus on risk ought to underline that there are differences between the techniques for emerging market investing and the skills needed to invest in developed markets. Chan says this can perplex colleagues from other departments who do not have “their EM lens on”.
Questions need to be asked about subjects such as subordination risk. Theoretically, senior secured creditors are always paid back 100%, but in practice this principle does not always hold in EMs. Since the financial crisis, the standard capital structure has come under more pressure and the risk that investors will find themselves in a subordinate position has increased.
“We like to think we’re higher up in the credit structure, but for certain regions we still find you either have the same rights as shareholders or you’re subject to how much you can force shareholders to play ball,” says Chan. “A lot of bond investors have found that the reality is that you need to understand the covenants, or your rights within the company structure.”
A difficult case concerns Chinese companies, because regulation prevents investors from owning onshore assets. This can complicate claims from overseas investors.
“In China, all the bonds are issued offshore,” she says. “They’re mostly issued off a Hong Kong-listed entity and you have no claim to any of the onshore assets. All you might hope to get is shares of the subsidiaries, which have no assets. Investors need to understand this subordination risk, especially in a recovery situation.”
But Chan stresses that these difficulties can be overcome. As long as the risks are correctly forecast and incorporated into the price, investors can still reap rewards. “Doing a lot of homework to understand the risk allows you to price the risk and to get the correct risk-return profile for any company you own,” she insists.
Chan believes that continued issuance will bring more investors to the market, improving liquidity and establishing this asset class as a safe and trustworthy means of gaining exposure to emerging market growth. “It’s a different market today from what it was a few years back,” she says. “It’s huge now. Emerging market global bonds are about 13% of global bonds, and EM corporates are the fastest growing within that.”
Esther Chan is portfolio manager on Aberdeen’s emerging market desk
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