2022 has been a challenging year for fixed income assets and the emerging market corporate space has been no exception. We are more constructive on the asset class going into 2023 and will seek to select the right notes to compose a portfolio well positioned for 2023.
Return forecast: a solid 7.5-12.5%[1]
2022 has been a challenging year for the emerging corporate bond market, which posted a negative return of -13.60%[2]. The war in Ukraine triggered a spike in commodity prices and led to sharper than anticipated spread widening. In this environment, our strategy[3] managed to generate a net excess return of 1.1%.
Looking into 2023 we expect volatility to remain high. Nevertheless we now hold a more constructive view based on attractive absolute valuations, resilient fundamentals and a technical picture that is looking benign over the next 12 months. We expect a gross total return of 10-15% for 2023[1] aided by a historically high carry (7.6%) together with up to 100bps in spread tightening from current levels. Given our expectation of a realised default rate of 4%[1] across EM (emerging market) corporates together with a historical average recovery of $39 cents, we calculate credit losses of 2.5%[1] for a net return forecast of 7.5%-12.5%[1].
Attractive fundamentals: Strong balance sheets, lower default rates and manageable credit deterioration with BBB- average rating
Emerging market corporates are entering 2023 with strong balance sheets and are well positioned compared to developed market peers. While we are still awaiting FY22 reports, LTM net leverage for EM companies was at 1.5x, significantly below their US Corporate counterparts at an average estimated level of 2.5x[4].
We expect some weakening of fundamentals going forward. The latest reporting cycle has shown that margin erosion is taking place across cyclical industries such as chemicals, petrochemicals and real estate. While some companies have shown strong ability to pass on higher costs to their customers, generating top line nominal revenue growth, their degree of control over input costs has been weaker, leading to lower profitability and higher leverage ratios. We are therefore looking for opportunities in industries where issuers exhibit some degree of pricing power and our strategy currently favours sectors such as non-cyclical consumer sector, TMT, and infrastructure as more defensive plays.
Emerging market issuers have extensive experience of past crises where capital markets have been shut over prolonged periods and are generally more proactive in managing their debt maturity profile. According to JP Morgan data, there were $78bn of tenders & calls in 2022 and $130bn in 2021. Consequently, there are limited maturities coming up in 2023 for the asset class overall.
We still see heightened refinancing risks for the lower rated issuers as the cost of refinancing has reached the highest level since the Global Financial Crisis. Due to our expectation of elevated refinancing risk, we are positioned defensively, limiting our exposure to lower quality issuers with large near-term maturities.
We expect default rates in 2023 to normalise from historically high 2022 levels affected by weakness in the Chinese real estate sector and numerous defaults of Russian and Ukrainian companies following the Russian invasion of Ukraine. We forecast high yield default rates of 6-8%1 in 2023, equivalent to 3-4% of the entire EM corporate market.
Positive technical factors: Rebound in issuance, strong reflows, modest net issuance
2022 was expected to be a year of high issuance matching 2021s previous record of $541bn5. Elevated volatility in risky assets and US Treasuries led to a collapse in supply as issuers struggled to access the USD denominated primary debt markets.
Emerging market hard currency outflows reached $85bn[5] in 2022, however for 2023 we expect the level of outflows to abate and strategic investors with a long-term view to reinvest in the market. We also forecast marginally higher gross issuance and neutral net issuance for 2023.
Valuations: historically elevated, attractive relative value
We currently view the asset class as attractive. EM corporate spreads are cheap as they remain around one standard deviation above the 5-year average, whilst relative value is also compelling with the attractive pick-up in spread over US Corporates and EM Sovereigns.
We particularly note that there are pockets of value in investment grade EM corporates that trade exceptionally cheap vs EM sovereigns at double the 5-year average spread as well as in the EM corporates rated AA, BBB, BB and B that trade at a decent premium vs comparable US corporates.
Our approach: a relative value-driven corporate credit investment process complemented by strong sovereign and ESG risk analysis
Over the past 10 years we have developed a unique relative value approach aiming to identify mispriced market opportunities. This active, fundamental, bottom-up process relies on proprietary tools integrating ESG factors whilst operating a disciplined approach to risk management. We leverage on the expertise of more than 30 credit and ESG experts. Our cautious approach of governance issues is key in markets where many issuers still lack transparency. As a result of our many meetings with corporate issuers this year, we managed to avoid the weakest credit profiles. Our Sovereign team’s comprehensive analysis serves as an input to our own as we avoid countries with poor political and economic outlook.
Similar to a piano and its wide range of keys, the EM corporate space offers multiple opportunities for all types of investors. As EM specialists, we rely on active management of risks and a rigorous bottom-up approach, integrating ESG factors in the aim to exploit the most attractive opportunities and compose a robust portfolio that resonates across all market environments.
------
All our investment strategies involve risks, including the risk of loss of capital. The main risks associated with the strategy are: Risk of capital loss, Interest rate risk, Credit risk, High Yield risk, Liquidity risk, Derivative risk, Counterparty risk, Emerging Market risk, ESG Investment risk.
ESG Investment Risk: The non-financial objectives presented in this document are based upon the realization of assumptions made by Candriam. These assumptions are made according to Candriam’s ESG rating models, the implementation of which necessitates access to various quantitative as well as qualitative data, depending on the sector and the exact activities of a given company. The availability, the quality and the reliability of these data can vary, and therefore can affect Candriam’s ESG ratings. For more information on ESG investment risk, please refer to the Transparency Codes, or the prospectus if a fund.
The Fund’s Risk level is 4 on a scale from 1 to 7.
------
[1] Candriam forecast. The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. What you will get will vary depending on how the market performs and how long you keep the investment/product. All our investment strategies are exposed to risks, including the risk of loss of capital.
[2] Measured by JPM Broad Diversified Index 1st January to 30th November 2022 in USD
[3] Candriam Bonds Emerging Market Corporate, net performance in USD, Institutional share class, 1st January to 31st October 2022. Reference index is JPM Corp EMBI Broad Diversified USD RI. Past performance is no guarantee of future returns.
