Comeback after a pause: inflows in emerging market corporates likely

The public at large – and therefore investors too – tends to see emerging markets as being a bit of a roller-coaster ride. This perception is incorrect, however; for one thing, the emerging market (EM) universe is too heterogeneous for that to be the case. Cautious optimism is the prevailing mood among investors at the moment – notwithstanding the somewhat uninspiring news emanating from the biggest emerging market of all: China. We therefore expect to see a resumption of inflows into the emerging market corporates asset class in the second half of 2023. This is, however, contingent on a further decline in interest rate volatility and assumes global interest rates remain at a high level but do not shoot up any further. A falling US dollar and attendant appreciation on the part of EM local currencies would be another positive factor. The fact is, stable-to higher EM currencies have a strongly supportive effect on investors’ risk appetite given that inflows into the asset class are an important performance driver.

Generally speaking, EM corporate bonds have proved very resilient in the past few years. Real returns are at their highest level in years, amounting to 9.5% in the high-yield segment (CEMBI Broad Diversified HY in USD) and 7.25% within the broader index (CEMBI Broad Diversified Composite in USD). Corporate fundamentals remain solid. In addition, the impact of the two biggest negatives of the past year – the significant tightening of interest rates and the war in Ukraine – is steadily waning. What’s more, in contrast to the ECB and the Fed, EM central banks began combating inflation at an early stage and now have sufficient headroom to ease monetary policy and stimulate their economies.

On a risk-adjusted basis, valuations of EM corporate bonds are just as attractive as those of EM sovereigns as well as government and corporate bonds in the industrialised countries, although they have slightly underperformed developed bond markets this year. They therefore have the potential to catch up and are likely to increasingly shift back to the centre of investors’ attention – even if valuations are not hugely attractive by historical standards. This is partly related to the fact that the balance sheets and net debt of EM countries have improved significantly in recent years. Of course, there will always be certain sporadic events – such as the war in Ukraine – that have the potential to spark upheaval in the markets, with individual regions and countries being dragged into the maelstrom and credit spreads widening. As we saw with Russia, the war led to complete exclusion from indices; for that reason, any spread widening needs to be viewed in context.

As for default rates, we anticipate a gradual easing for EM corporates. The high default rates of the past couple of years have been exacerbated by the real estate crisis in China and the war in Ukraine, with EM corporate bonds totaling over USD 200 billion having defaulted or ending up in distressed exchanges since 2021 (this is equivalent to 23% of the EM HY market). This situation is unprecedented, since it was mostly concentrated in real estate in China and Russian bonds. We think it is highly unlikely that there will be a repeat of this development, at least on such a scale. The fundamentals of EM corporate bonds therefore look solid. Many companies are in fine health; indeed some are in a better position than they were pre-pandemic. On the assumption of a “mild” US recession, or a soft landing, the default rate is likely to fall in 2024 on a year-on-year basis. The refinancing risk is acceptable, and although the risks of a deeper and more protracted global recession remain, we are optimistic.