Emerging Market Corporate Credit Performance: A Blind Search For Yield? (Part I)

The global search for yield has suppressed emerging market corporate bond spreads, but EM corporate credit now offers a very poor risk-reward profile.

Emerging Market Corporate Credit Performance | A Blind Search For Yield?

O ur EM team uses its Corporate Health Indicator (CHI) to assess the financial fundamentals of EM corporate bonds. The CHI is a composite of key financial ratios and it has dropped back to its 2008 lows while EM corporate spreads have not widened much. This suggests that EM debt issuers’ credit quality has deteriorated markedly while the blind global search for yield has kept this market well bid. But not only have EM corporate spreads deviated from the EM CHI, they have also diverged from other EM macro variables. Specifically, EM share prices have been extremely weak but EM corporate credit spreads have not widened meaningfully.

Historically, stocks and corporate credit spreads have been correlated, and we do not see any reason why they should be decoupling. Similarly, EM currencies have depreciated notably in the past year, making U.S. dollar-denominated debt more expensive to service for EM corporations. As a rule, this should lead to wider spreads. However, the correlation between EM currencies and EM corporate credit has also broken down.

Finally, commodity prices have historically been correlated with EM corporate spreads as many U.S. dollar debt issuers within the EM universe are large commodity companies – but the sell off in commodity prices over the past 18 months has not been matched by a sufficient widening in EM corporate spreads.

Emerging Market Corporate Credit Performance: A Blind Search For Yield? (Part II)

The path of emerging market corporate bond spreads has diverged from other macro variables. Our Emerging Market Strategy service believes the main reason for this is the global search for yields.

Emerging Market Corporate Credit Performance- A Blind Search For Yield?

L arge portfolio inflows into global bond funds and the high popularity of EM assets over the past several years together have spurred investors to bid up corporate bond prices (suppressing credit spreads) despite the deteriorating credit quality among EM corporate debt issuers.

Nevertheless, strength driven by capital flows and not by healthy/improving fundamentals always turns out to be temporary. Investors will eventually realize that EM corporate creditworthiness is worsening, and the asset class will be at risk of a selloff. Massive inflows and surging debt issuance by EM companies also suggests that investors’ holdings of developing nations’ corporate bonds are elevated and a selloff could trigger an unwinding of long positions.

Bottom line: EM corporate spreads have markedly diverged from other EM financial market variables. Going forward, the odds of sustained decoupling are low – EM corporate credit is at risk.


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