Emerging Market (EM) Corporate Debt Views—Q1 2021

    Franklin Templeton Fixed Income

    In the tug of war between fundamentals, which have been deteriorating due to the ongoing COVID-19 pandemic, and technicals, which have been very strong due to the ensuing policy response, we believe technicals will prove the stronger influence on emerging market corporate bond performance in coming quarters. As the hunt for yield intensifies, we expect more capital to flow into the EM corporate asset class, while reduced market volatility will draw positioning down the credit curve into higher yielding opportunities. Gross supply will no doubt remain elevated, but we anticipate the growth of the market in net terms will not assuage the grind tighter in spreads, particularly given the strong regional bid from Asia. Over the next 12-month period, we maintain a positive, moderately bullish view on the emerging market corporate asset class, with a bias toward a more constructive stance. This view is consistent with our bullish view on EM sovereign debt, considering EM corporates’ performance year-to-date, which reflects their higher average quality and lower beta.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Credit fundamentals deteriorated in the first half of 2020. While investment-grade leverage has now exceeded its previous peak in 2016, the high-yield (HY) portion of the market has remained under control, implying a growing differential with the US high-yield market where leverage has risen sharply. Besides the double-digit percentage falls in revenue and EBITDA, we have seen a modest increase in debt levels. Analysis of use of proceeds data suggests that most new debt is being used to refinance short-dated and expensive funding, and so is more virtuous in nature than the capex splurge seen in the commodity boom years. Encouragingly, we see some evidence of a pick-up in underlying demand, spurred by infrastructure spending and fiscal stimulus. The expectation from here is that credit metrics gradually improve, although precise multiples will depend on a multitude of factors including net debt issuance. This is more likely to come through on the investment-grade side, we would argue. The other complicating factor is the extent and timing of downgrades to HY.

    Banking sectors around the emerging world have seen earnings slide, asset quality deteriorate, and capital ratios fall; however, all of these would have been substantially worse were it not for the forbearance and policy stimulus that has been introduced to counter the effects of the pandemic. Our belief has been and continues to be that banks are part of the solution in this crisis, rather than part of the problem, and so they will generally be supported and prevented from failing for fear of piling financial stability risks onto already fragile economies with limited policy ammunition left in the armory. Of course, this does beg the question, what happens when the music stops, and central banks decide to rein in policy support and phase out forbearance? Our experience in Russia post the 2014-2015 forbearance is that banks might well be allowed to fail once the dust has settled and regulators deem the system robust enough to absorb ensuing volatility. Although markets have bounced back quickly from COVID-19, we fully expect asset quality indicators to continue to deteriorate, reflecting the gradual reduction of support measures. We think it unlikely that this will cause a delayed shock to global markets, but it probably will put continued pressure on earnings for many quarters to come. Besides the cost of provisioning against bad debt, banks are also suffering from margin pressure and very mixed lending demand.

    High-yield defaults have surprised to the downside, with the year-to-date default rate at around 4% compared to some estimates from earlier in the year close to double digits. EM corporates have survived the COVID-19 shock thanks in part to their relatively robust starting point but also because of the macro prudential support shown by governments and central banks. On top of this, the refinancing schedule has generally been manageable, with the strong regional bid in Asia helping to support steady new issuance from that part of the world, where it was needed most. This will be another year where EM HY corporate default rates are lower than the United States.

    By region and country, we would expect Latin America to record the highest default rate, as it usually does because of its lower average rating and stronger correlation with commodity prices. Central and Eastern Europe Middle East and Africa (CEEMEA) will likely be second-highest of the three regions, in part because of the denominator, which works in Asia’s favor because of its size. Nevertheless, we expect Asia to top the list of number of defaults in 2020.

    China has come through the pandemic better than any other large EM country and its external debt-issuing companies have generally fared well as a result, responding in part to a combination of forbearance support and government stimulus. In Europe, there has been little discernable trend by sector or country, although property and commodities are perhaps a running theme. Turkey obviously remains in focus, although we have seen the country come through several periods of foreign exchange volatility relatively unscathed. In Middle East and North Africa (MENA), there have also been a few defaults linked to poor governance, which hopefully suggests a lower correlation with the rest of EMs. Recovery rates have been in line with our expectations, and above those seen in the United States. We expect recoveries to trend upward from the current level of 35% toward the long-term average of 40%.

    We see risk factors for EM corporates falling into two categories: policy and politics. Our analysis has shown that a sharp selloff in risk-free rates, usually sparked by a change in interest-rate policy, is dangerous for the asset class. Likewise, a material strengthening of the US dollar can prompt disruptive capital flows and lead to underperformance. Neither of these is particularly likely in the near term, in our view, but we remain vigilant. Politics refers both to geopolitics— which will no doubt be influenced by the foreign policy stance of President-elect Biden’s administration—and the potential for further upheaval at the individual country level, of the sort seen in plenty of EMs thus far in 2020.

    The US election result is perceived to be a positive for EM corporates, although the “transition” has already proven to be disruptive, with President Trump’s executive order on November 12 impacting certain Chinese companies with links to the military. There is a reasonably high probability that the outgoing president will further target Chinese companies, although equity-listing related sanctions from the Securities and Exchange Commission will clearly be less disruptive to bonds. Looking beyond January 2021, our base case is that President-elect Biden will keep the pressure on China in order to protect technologies and supply chains that are critical to the US economy and national security; however, we expect him to conduct foreign policy in a more orthodox manner, which is important to corporates looking to invest and expand in the EM world. By extension, we expect that the United States under President-elect Biden will re-engage with the World Trade Organization and other multilateral agencies including the International Monetary Fund, which should contribute to reduced trade tensions and help to restore confidence in globalization. We also expect the new administration to rejoin the Paris Agreement, which is thought to have certain positive implications for US-China alignment. One of the most significant changes in foreign policy could be relations with Iran, with the President-elect consistently favoring a return to the Joint Comprehensive Plan of Action. An oil-producing Iran could, on the margin, have negative implications for other commodity focused EMs.

    Supply remains very robust on most measures, although perhaps less exceptional than seen in the US corporate market. The year-to-date gross supply is slightly higher than this time last year, driven by investment grade, which is up on last year, whereas high yield is lagging. By region, Asia still dominates, accounting for 66% of the total gross supply year to date, 40% of which is China. Refinancing is the key driver of new supply, with companies looking to take advantage of historically low yields to refinance with longer debt at a lower cost. We consider the refinancing outlook to be manageable, especially when considering the regional breakdown which is heavily tilted toward Asia.

    Previously, our forecasts incorporated a degree of uncertainty in Q4 2020; however, this has proven to be too conservative, with US election results, COVID-19 vaccine news, and continued global policy support helping to drive spreads tighter over the past three months. Although valuations have come in a long way from the wides of late-March, we believe there is ample room for further tightening.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

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