EM corporate bonds compensation at six-year low

Investors are getting the least compensation in six years for leaving the safety of US Treasuries and taking on the risk of emerging-market corporate bonds. 

A Bloomberg index of dollar-denominated EM company debt has rallied since October, reaching the highest level since February 2022. That’s sent its yield premium over Treasuries down to 216 basis points, less than half of the spread seen as recently as 2022. A similar measure shows emerging-market companies are now able to borrow by paying just 133 basis points more than their US peers.

Yet, instead of balking at such low risk premiums, investors are betting on further gains. They say EM yields are high enough from a total-return perspective, and locking in income streams of close to 7% will look even more attractive whenever the Federal Reserve starts easing and global borrowing costs fall. Current demand for the bonds is also fueled by technical factors ranging from shorter average durations to limited supply of new bonds, they say.

“Even with thin spreads, total valuations are comparatively attractive if investors are looking at a carry trade-strategy,” said Arnaud Boué, executive director and senior fixed-income portfolio manager at Bank Julius Baer in Zurich. “We should see again a growing demand for EM corporate bonds when the Fed actually starts cutting rates as investors will seek higher-yielding papers.”

While the overall appeal of EM remains clouded by Fed delays, faltering growth in China and juicy yields on US debt, the related rush into all sorts of dollar-based assets is driving demand for hard-currency corporate bonds everywhere, including the developing world.

The buzz is also echoing in the primary market, where EM companies have raised $131 billion so far this year, a 33% jump over the same period in 2023. Yet, new dollar-bond sales haven’t kept pace with maturities, supporting higher prices for existing bonds. In the past two years, there has been net negative financing of $413 billion, according to Luke Codrington, the co-head of EM global fixed income at Pinebridge Investments in London.

“The thin spreads have been driven by factors including limited supply, relatively strong fundamentals and muted election risks,” said Codrington. “Alongside these factors, we have seen a positive outlook for most EM sovereign credits, which have resulted in limited sovereign-driven EM corporate rating downgrades.”

Emerging-market corporate dollar bonds became popular at the height of a sovereign-debt crisis two years ago, when their average yields were close to 10% and investors spooked by local-currency risks sought relatively safer options. The rally has intensified in the past six months as default risks subsided across the most vulnerable countries in the wake of bailouts from the International Monetary Fund and other lenders.

“EM corporate spreads have played catch-up to US corporates this year after underperforming in the final months of 2023,” said Elizabeth Bakarich, a money manager at AllianceBernstein. She said technical factors including a shorter average duration for emerging-market bonds — at 4.74 years compared with 6.87 years for US companies — has contributed to the recent outperformance.

'BROKEN MARKET'

The frenzy in the corporate-bond market is worrying a minority of investors who say ignoring risk spreads and chasing nominal yields can be dangerous when global markets take a turn for the worse. Peter Varga at Erste Asset Management, one of central Europe’s largest money managers, describes the market as “broken.”

“As I started my career in 2000, I used to learn to compare spreads to risks,” Varga said in an interview from Vienna, where he’s a senior portfolio manager. “Now I see markets where negative news is ignored, leverage goes up, and nobody really cares. Any type of liquidity premium is getting priced out. People just buy absolute yields, and do not care about fundamentals.”

The rally wasn’t dented even as US yields reset to higher ground and money markets pushed the timing of a potential Fed rate cut from June to November. Some investors say they’re bullish on the securities because the global economic and monetary landscape has improved irrespective of the Fed’s stance.

“The repricing of Fed cut expectations has failed to damage sentiment towards EM corporate debt because US and global growth has been much better than expected and the fears of a hard landing in the US and other DM economies have been allayed,” said Paul Greer, a money manager at Fidelity International in London. “The positive performance from EM sovereign debt is also supportive of EM corporate credit, with a wide number of high-yielding countries across EM enacting important macro reforms and fiscal improvements.”

For now, those improved fundamentals, along with momentum and technical dynamics, appear to be more important to investors than the thinning spreads. 

“Funds are being reallocated from money-market funds into developed-market investment-grade asset classes, which is providing crossover demand tailwinds for select segments of EM corporates,” said Omotunde Lawal, head of EM corporate credit at Baring Investment Services. “Overall EM corporate fundamentals are also very healthy; so barring idiosyncratic moves or geopolitical driven volatility, we should see some level of resilience.”