The Journal Vol 4. Chapter 3
The Journal Vol 4. Chapter 3
Important Information

Evolving in adversity: The under-appreciated resilience of emerging market corporate debt

Investec Asset Management’s emerging market corporate debt team conducted an in-depth study on how emerging market companies have responded to the challenging political and economic environment over the past three years. In defiance of headline-grabbing concerns about debt and risk in emerging market government bonds, corporate bonds and currencies, our findings point to emerging market corporates as a diverse asset class showing surprising resilience that we believe has gone underappreciated by markets. This suggests that investors have overestimated and mispriced the risk in emerging market corporate bonds. As a result we believe they currently offer a wide range of investment opportunities for active, bottom-up investors.

Evolving in adversity: The under-appreciated resilience of emerging market corporate debt

Evolving in adversity: The under-appreciated resilience of emerging market corporate debt

Victoria Harling, Strategy Leader, Emerging Markets Corporate Debt
Tammy Lloyd, Investment Specialist

Responding and evolving in challenging times

The world has been less calm for emerging markets since 2013. Domestic economic growth has softened. The top ten emerging market currencies have weakened, while emerging market government and corporate bonds have experienced volatility. We believe investors may have overestimated the risk of emerging market corporate bonds.

To test this hypothesis, we undertook in-depth analysis of the 347[1] non-financial companies in the JP Morgan CEMBI Broad Index, representing the core emerging market corporate bond issuer investible universe. Our study revealed that many emerging market companies have demonstrated considerable resilience and continued to thrive. On average, emerging market corporates are increasingly global, have lots of cash and are practiced in operating during downturns.

A large portion of emerging market companies are blue chip

We believe that many of the larger companies that issue US dollar bonds represent the blue chips of the emerging market corporate universe. The largest emerging market companies are comparable in size to the largest companies in the US and Europe. They are as (or more) significant to their home economies and domestic equity markets as the big US companies.

Our analysis showed that, in absolute terms on average, emerging market investment grade companies in our universe are two-thirds the size of US investment grade companies, but the largest emerging market companies that issue high yield bonds have more scale than US and European high yield companies, measured by average revenue.

Figure 1: Many large EM corporates are blue chips

Source: Investec Asset Management data, JPM Morgan Cembi Broad Index, BoAML. Indices: the euro Non-Financial Index; US corporate Index; World Economic Outlook data 2015, Bloomberg data, a selection of the largest EM, European and US companies by FY 2015 revenue in USD, 24 August 2016.
* Top ranked in European HY Index.

Diversification boosts resilience

Due to a concerted effort over time to manage the main challenges of corporate life – sales growth, margins, financing, and the corresponding exchange rate complications – emerging market companies have evolved. The revenue sources of the 347 companies we analysed show that many draw revenues from multiple markets and not just because they sell commodities into a global market.

Brazilian consumer sector examples
The Brazil corporate universe is one example. Brazilian consumer companies earn over 60% of their revenues in their home market, with the remainder coming from the rest of the world. JBS, headquartered in São Paulo, is the largest protein producer in the world. Beef producers Minerva Foods and Marfrig earn around three-quarters of their revenues outside Brazil from exports (mainly to other emerging markets such as Russia, China and Egypt). This revenue diversification makes them comfortable holding most of their debt in US dollars. Minerva Foods, for example, barely saw any increase in leverage in 2015 due to the fact that the company leveraged its depreciating Brazil cost base against its multi-currency earnings, helping to improve margins.

Brazilian industrials
Brazil industrials are more diversified than consumer companies and earn over 60% of revenue abroad. Outside Brazil, Latin America and the US were significant contributors to Brazil’s corporate revenues. Companies such as Gerdau (steel producer), Tupy (auto parts), Embraer (aerospace) and Votorantim (cement producer) have either used their competitive advantage to develop exports or made acquisitions abroad to become globally competitive. Tupy, a cast iron engine manufacturer, lists Ford, Caterpillar and Volkswagen among its top ten customers. It derives only 18% of its revenues from Brazil, with the rest denominated in US dollar and euro from international customers. Tupy produces entirely from factories in Mexico and Brazil, and its strong 17.5% margins in 2015 were no surprise.

Broad emerging market examples
Significant diversification is not just a Brazilian phenomenon, but was evident in the material foreign earnings recorded by other large emerging markets, notably Mexico (37%), Russia (36%) and South Africa (62%)*. A number of emerging market companies use hard currency exports to boost margins. For example, Russian steel producer NLMK earned 38% of 2015 revenue from selling to its Western European and North American subsidiaries that customise the semi-finished steel products for end customers, including auto and equipment manufacturers. Turkish industrial Arçelik earned almost 60% of revenue in 2015 from exporting its own consumer durable brands, such as Beko and Grundig. Emerging market companies also export expertise to earn hard currency revenue or diversify local currency revenues. China-based Country Garden was the largest property developer in Malaysia in 2014 and 2015. Its developments there include the landmark Forest City, where it will build residential property on four man-made islands that it designed over the next twenty years.

*Figures based on a simple average.

Diversifying through acquisitions and expansion
Other companies have used acquisitions and organic expansion to change their sources of revenue and earn hard currency.

CK Hutchison Holdings, one of the world’s largest conglomerates, earned just 16% of 2015 revenue in its Hong Kong home market after years of acquisitions. Its partnership with Russian telco Vimpelcom in Italy will create the largest operator there with 31 million subscribers. Chinese companies spent US$105 billion on acquisitions abroad in 2015 and US$135 billion in the first half of 2016, according to Dealogic. China-based Haier spent US$5.4 billion buying GE Appliances, which makes Haier a significant shareholder of Mexico-based Mabe. Mabe is one of the biggest exporters of gas ranges and fridges into the US market. Most of these appliances are branded GE and are made in its San Luis Potosi plant, which is the largest plant producing kitchen products in the world, responsible for 60% of GE appliances bought in the US. Haier gains access to one of the strongest global consumer brands from this acquisition, while Mabe bondholders will benefit from the opportunity to enter new markets, such as China.

Even domestic focused companies have found ways to diversify


Looking at our study from a sector perspective, we found industrials and consumer companies have used exports to reduce exposure to their home market. Oil & gas, metals and mining and some pulp companies typically earn revenues in US dollars, making these sectors the least reliant on domestic macroeconomics. In contrast, telecom, media and technology (TMT) companies were among the most domestically oriented. They typically focus on domestic consumers and charge in local currency.

However, proactive merger and acquisition strategies mean that telecoms companies in markets such as Qatar, India and China earn over 25%, and up to 70%, of revenue outside their home market. Emerging markets have created national champions that have expanded abroad to dominate their markets globally.

In turn, developed market TMT companies have found an important driver of growth in emerging markets. In 2015, Vodafone earned 32% of revenue and found 72% of its customers in emerging markets. Chinese telecoms equipment and phone manufacturer Huawei counted Vodafone as one of its largest customers following Huawei’s expansion out of China since 1994. Huawei is now the dominant supplier to the US$170 billion network carrier market, alongside Sweden’s Ericsson. It is also the third largest global manufacturer of smartphones, after Samsung and Apple, with over 100 million phones shipped worldwide in 2015. Mexico’s America Movil – the world’s fourth largest telecom operator by subscribers – has told investors that it would like to participate in consolidating telecoms in Europe, particularly Eastern Europe, a region where it sees similarities to Latin America ten years ago.

Source: Bloomberg company data, Investec Asset Management analysis of 347 companies, company data as reported for FY 2015, based on simple average.
Note: Figures based on a simple average.

The rise of local currency financing

We found that where emerging market economies, such as China and India are less open, their companies are less globally diversified. The majority of Chinese companies in our universe earned over 90%[2] of revenue locally, mainly because the size and growth of China’s market have not driven them to expand worldwide. Chinese companies also draw support from a strong local investor base that facilitates multiple financing sources. China has opened up local bond markets with a new regulation that ruled that companies could issue up to 40% of their onshore China asset value in local bonds. Subsequently, US dollar issuance has significantly declined.

China’s large real estate developers issued the equivalent of US$37.3 billion in local renminbi-denominated bonds, but just US$3.2 billion in offshore US dollar-denominated bonds in 2016 year-to-date (August). This is in contrast to previous years, when the Chinese real estate sector issued US$19 billion in 2013 and 2014 respectively in US dollar bonds to finance construction, and new bond issuers grew from five in 2010 to 35 in 2016[3].

Renminbi bonds have also reduced overall interest costs. The lack of US dollar bond issuance has created scarcity value for existing bonds and compressed USD yields almost flat to very low renminbi yields, leading to much lower financing costs. Developers may issue far fewer US dollar bonds in future, as they prefer local currency financing to match their mainly local currency revenues.

While China’s local bond market is especially large, good emerging market companies are also able to tap local bond investors in other markets too.

America Movil said in 2012 that it preferred local currency debt and would only rarely issue US dollar bonds. It has repeatedly tapped the MXN982 billion Mexico non-financial corporate bond market. Elsewhere, Poland’s Polkomtel and Indonesia’s Indosat have refinanced euro and US dollar debt into local debt. Meanwhile, iron ore producer Vale issued almost BRL5.5 billion in local bonds in 2015, some of which were used to fund capital expenditure. It is also expected to issue US dollar bonds in order to keep its US dollar revenues and liabilities in line, as will many emerging market companies with diversified revenues.

Larger than hard currency bond markets in absolute terms, local bond markets are less liquid and less deep at this stage, but we expect them to continue to grow and complement US dollar funding in certain markets.

Figure 3: Chinese Real Estate Issuance

Source: JPM, BoAML, BBG, Wind, September 2016

Emerging market financing partnerships

Financing between emerging market countries is another partnership that has emerged more recently. European and US banks cut the number of loans in emerging markets to address domestic issues with their balance sheets following the 2008 crisis. At the same time, emerging market governments have used bonds to separate debt funding for their quasi-sovereign entities from their own balance sheets.

Many emerging market companies have used US dollar bonds to replace expensive loans and lengthen maturities. Those earning US dollar revenues from cross-border transactions and international acquisitions have found US dollar financing a legitimate match. This explains the growth in emerging market corporate bonds which, since 2009, have increased from over US$600 billion to over US$1.75 trillion***. Some 80% of the companies in the bond market have listed equity, so companies have more financing options and oversight.

Loan and equity financing between emerging market economies

Companies have also found loan and equity financing from emerging markets. For example, Russia’s leading mobile operator Mobile Telesystems was granted a US$200 million loan from China Development Bank to buy telecoms equipment from Huawei.

On a larger scale, Chinese banks have lent billions of US dollars to Brazil’s state oil company Petrobras and Russian oil and gas producer Rosneft since 2014. Russia’s own government supported its companies with a US$30 billion repo facility in 2015, to facilitate US dollar funding. It is not just Chinese banks reaching out: Saudi Arabia’s Salic investment arm bought a 19.95% stake in Brazil beef producer Minerva Foods for US$188 million, as a new strategic investment.

This year, another example of the growing equity deals between emerging market companies, Qatar Airways bought a 10% equity stake in South American carrier Latam in July. The deal was designed to capture a new marketing opportunity and diversify away from customer demand driven by oil revenues.

Figure 4: Emerging market corporate bond growth

Source: JP Morgan.

Conservative approach to debt helps manage currency volatility

Our analysis shows that larger emerging market corporates with outstanding bonds can continue to weather further declines in foreign exchange reasonably well.

Examples in utilities
Many utilities, such as Chile-based Guacolda and Indonesia-linked Cikarang and Star Energy, charge US dollar-linked tariffs to clients, so the foreign exchange impact is limited.

The transport and commodities sectors
The transport sector is also helped by US dollar-linked charges, which means margins rise and leverage drops when domestic foreign exchange declines. The same is true for commodity producers who earn revenue in US dollars, with a local cost base. Despite the jump in leverage in high yield commodity producers following the oil price correction, we do not expect a wave of defaults in emerging market commodity companies. Small producers are a minority and many companies benefit from sovereign support, unlike in the US corporate bond market.

Telecoms more exposed
Equally, some sectors such as telecoms are more exposed as they charge in local currency and have some hard currency costs and debt, especially where revenues are focused on a single country. For example, leverage in Russian mobile operators MTS and Vimpelcom increased 20% and 30% respectively after the rouble’s 20% depreciation in the first half of 2015. This risk is offset by the companies’ high cash balances and low absolute leverage. A weak domestic currency can, however, compound an underlying challenge: Digicel, a Caribbean company rated high yield, has seen weak foreign exchange turn organic growth negative, which has sapped its ability to reduce already high total leverage of 5.8x.

Leverage remains manageable

Despite currency volatility, leverage in emerging market companies has not jumped to unmanageable levels overall and is still lower than developed market peers. Our analysis tells us that leverage within our data set, on average, remains manageable (see Figure 5). This shows that many companies have healthy cash balances. We believe many emerging market companies maintain better liquidity because domestic market volatility has tested their ability to survive over time.

A key priority of seasoned management teams is to ensure they maintain a cash cushion. Some, as shown recently by large companies in Turkey, keep a significant portion of cash in hard currency. The fact that Turk Cell and Turk Telecom, and industrial Koch, hold the majority of the cash in US dollars was one reason they maintained an investment grade rating with Standard & Poor’s (S&P) rating agency after an attempted coup on the government in July. S&P moved the sovereign to high yield.

Bank of America Merrill Lynch shows that emerging market corporates in aggregate had cash worth 36% of their total debt compared with 16% in the US at the end of 2015, a similar level to the last few years. Emerging market companies tend to have conservative ratios, in relative terms. US companies have 3.1x net leverage compared with emerging market companies at 2.3x, in aggregate. Emerging market companies that issue non-investment grade bonds have net leverage of 2.7x, which is still much lower than in the US (over 7.7x, or 4.8x excluding energy companies[4]). Our data shows that leverage remains manageable on a sector basis.

Source: Bloomberg company data, Investec Asset Management, analysis of 347 companies, company data as reported for FY 2015, based on a simple average.

Political risk

Emerging market companies are not only vigilant about financial volatility, they may also face political risk from time to time. All corporate investors regardless of geography must remain mindful of political and governance risks.

Brazil’s unravelling of a web of bribery around state-owned oil producer Petrobras impacted several Brazil companies. Last year China conducted a widespread investigation into corruption, where a number of executives were removed and prosecuted, albeit with far less dramatic implications for investors. Russia also removed the top management of state-owned companies in 2015.

While companies can diversify their revenues by increasing their global footprint, jurisdiction risks increase. This remains true for any corporate, be it developed or emerging market based. Companies such as BHP Billiton in Brazil, MTN in Nigeria and Verizon in Venezuela are good examples.

We weigh politics as almost equal to economics in our macroeconomic framework because of the implications for corporate spreads. Following the coup in Turkey, corporate spreads initially widened slightly more than sovereign spreads despite the strength of the companies. We saw this as overdone. On the positive side, the succession of former President Christina Fernandez de Kirchner in Argentina with a market friendly government in 2015, re-opened bond markets in 2016 for the better Argentine corporates.

Large universe allows investors to manage risk

The diversity of the corporate universe allows investors to manage their risks by choosing which companies and sectors to focus on. These could include, for example, exporters that might actually benefit from weak foreign exchange and avoid sluggish local demand, transport companies capturing global trade flows or domestic telecoms or cement producers leveraged to a recovery in foreign exchange and domestic demand.

Furthermore, we believe future defaults in emerging market corporates are unlikely to be much higher than developed market levels and are likely to be lower than the historic highs seen in the past. Many of the companies that currently issue bonds are high quality national champions with proven resilience. They are adept at finding alternative sources of funding – one reason US dollar bond issuance has decreased to under 70% of peak levels year-to-date. Many are inherently conservative and, when necessary, have been proactive at selling assets or raising equity to repair credit ratios.

Conclusion: A diverse, attractive opportunity for active investors

Our study into the emerging market corporate debt asset class revealed a diverse, dynamic and evolving investment universe, filled with bonds issued by high quality national champions with proven resilience and strong global brands.

As such, we believe it provides a unique investment opportunity for active investors with the ability to select companies and sectors that will benefit from current conditions.

[1] Note: The companies were predominantly selected as constituents of the JPM Morgan Cembi Broad Index, which is our primary index family. The companies are therefore part of our active coverage universe, and if not directly covered, are used to understand relative value and industry conditions. This group of companies makes up 90% of the index, excluding financials. Companies were excluded primarily because we were unable to obtain recent financial statements for private companies, or obtain financial statements that were directly relevant to the bonds in the index, or we believe the bonds don’t actively trade. Investec Asset Management’s sector leverage figures are not directly comparable to BoAML’s sector leverage figures due to different coverage universes and some calculations, such as the inclusion of restricted cash for certain companies.

[2] Simple average.

[3] JPM CEMBI Broad Diversified Index, July 2016.

[4] BoAML, as at December 2015.

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Resilience in an age of uncertainty

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