In recent years emerging market (EM) default rates have not been materially greater than those in developed market (DM) and thre former's bond covenant quality has also tended to be higher on average. Within the high yield (HY) area of EM debt, fundamentals are also improving and default rates are expected to decline this year.
Comparing default rates for EM corporate HY issuers with those of their US equivalents since 2000, two observations are worth highlighting. First is the close similarity in trend between the two series which suggests global cyclical factors, rather than regional idiosyncrasies, explain a large part of the default experience for both EM and US corporate issuers. Second, the magnitude of default rate has been broadly similar across cycles, with 2002 the only meaningful exception in the period surveyed.
EM and US corporate high yield historical default rates, 2000-2017 year to date
Source: JPMorgan, July 2017
With regard to sovereign debt, over recent years we have become more accustomed to associating crisis events with DM entities - the subprime crisis and European sovereign debt crisis being notable events from the past decade. While individual EM countries such as Ukraine and Brazil have seen crises of a geopolitical or recessionary hue, these events have been localised rather than global phenomena.
On aggregate, EM economies have matured considerably since the 1980s and 90s, and sovereign credit events have become more of a rarity. Using JPMorgan's Emerging Market Bond Index (EMBI) Global benchmark to represent the investable hard currency EM sovereign issuers accessible to international investors, only seven EM sovereigns in the index have defaulted since 2000. The adoption of flexible exchange rates, strengthened external balances, reserve accumulation and a move from external to local currency debt issuance go some way toward explaining this shift
Notable EM sovereign default episodes, 2000-2017
Source: JPMorgan, July 2017.
Regional disparities
Given the geographic breadth of the asset class, regional default disparities within EM can be significant. Over the past five years Latin America has experienced elevated default rates relative to the rest of EM, while the default picture in emerging Asia has been relatively benign. Latin America's default experience can largely be attributed to political and economic headwinds in Brazil. Brazil's economy continues to emerge from a severe recession, while a corruption scandal centred on state-owned oil company Petrobras has generated a considerable amount of political instability. Against this economic and political backdrop, corporate debt exposures increased significantly, profitability levels declined, leverage metrics deteriorated and defaults ensued.
While Asian corporates have also experienced a commensurate increase in leverage, the region's recent experience with defaults has been mild in comparison. Most of Asia's leverage build-up can be attributed to Chinese state-owned enterprises. The Chinese authorities have been at pains to avoid realising defaults that would adversely impact the asset quality of financial institutions' portfolios. However, with increasing
focus on financial and structural reforms, and signs that the authorities are now starting to allow more defaults occur, this rate could push higher.
Historical EM corporate HY default rates by region
Source: JPMorgan, July 2017
Covenant quality
Fundamental credit analysis extends far beyond the examination of a company's financial statements. Also important is an understanding of the degree of investor protection, measured by overall covenant quality. Moody's Investors Service computes bond covenant quality scores across regions which gauge the level of protection in six key risk areas: restricted payments, investments in risky assets, leverage, liens subordination, structural subordination and event risk (change of control)2. According to their analysis, EM Asian high yield bonds provide stronger investor protection than those from Latin America and Europe, Middle East and Africa. However, these three EM regions all scored better than the North American and global averages. Such protections could provide comfort for investors in the event a credit episode occurs and in our opinion further dispels the myth that EM lacks creditworthiness.
EM bond covenants in Asia, Latin America and EMEA are stronger than in North America
Source: Moody's Investors Service, May 2016. For illustrative purposes only.
Balancing risks
Looking ahead, with EM corporate default rates currently tracking close to 0.5%, we expect to see a significant decline in 2017's full-year default rate versus the 5.1% level recorded in 2016. Two factors are driving this improvement. From a top-down macroeconomic level, we expect the global economy to continue to experience broad-based and sustained growth. For EM this should translate into higher levels of domestic and export demand, and a more supportive backdrop for commodities. From a bottom-up perspective, EM corporate fundamentals are improving on the margin and most notably for Latin American and commodity sector names.
For Latin America specifically, gross leverage levels appear to be turning a corner, while for EM corporates more broadly, EBITDA margins and interest coverage ratios are all pushing higher. Relative to European and US HY corporates, EM credit metrics remain stronger in aggregate. With many EM companies now focusing on reducing their financing requirements and capital expenditure, this should ultimately translate into stronger cash flow generation and a more rapid deleveraging process.
While EM corporate HY spreads, at c430bps in August, are at the tighter end of recent ranges, such valuations may be justified when viewed against this improving fundamental backdrop. These valuations should also be evaluated in the context of the global low yield environment and EM corporate HY's relatively lower duration (c3.7 years) profile - a particularly appealing trait given the ongoing shift toward monetary policy normalisation.
Furthermore, index compositional changes over time need to be recognised. Over the past few years, several large EM countries have been downgraded from investment grade to HY. This automatically brought a majority of corporates from these downgraded countries to HY as well, even if many still retain investment grade-quality metrics.
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