Emerging markets high yield corporate bond yields have widened significantly over the second quarter of the year and provide a yield pickup over U.S. high yield of 1.1% (as of July 20, 2018). On a spread basis, the pickup is more attractive at 117 basis points. The spread advantage reflects the comparatively lower duration of emerging markets high yield, which has an effective duration of 3.7, or approximately 0.4 lower than U.S. high yield. But does this yield and spread advantage represent increased value in the asset class?
Emerging markets high yield corporate bonds have historically provided a yield advantage over their U.S. counterparts, though the relationship has inverted several times historically. The real and perceived additional risks associated with emerging markets, including political and liquidity risks, have generally led investors to demand a higher yield from an emerging market corporate bond versus a U.S. one, assuming all else equal (e.g., same industry and credit rating).
Ratings agencies also tend to demand more favorable metrics before giving an emerging markets issuer the rating it might receive were it domiciled in a developed market. In fact, the emerging markets high yield corporate index carries a BB- average credit rating, whereas its U.S. counterpart carries a B+ average.1 Despite a higher hurdle with ratings agencies, the emerging markets index still achieves a higher average rating to complement its higher yield and lower duration.
So does the recent selloff present a value opportunity for emerging markets high yield corporate bond investors? We believe it does, given the supportive fundamentals and lower credit and interest rate risk in the asset class. Emerging markets growth still provides a favorable backdrop both outright and relative to developed markets, although the repercussions of a trade war may pose a threat to this dynamic.
Leverage ratios and interest coverage among emerging markets high-yield issuers have improved steadily since mid-2016, as they have for U.S. high-yield borrowers. But investors are being compensated with approximately 30% more yield spread above Treasuries per unit of leverage for emerging markets high-yield bonds versus U.S. ones.
Emerging Markets High Yield Bond Advantage
Source: ICE Data Indices, LLC. Data as of June 30, 2018. Past performance is no guarantee of future results. See definitions and descriptions below.
High yield has grown into a sizeable segment of the emerging markets debt universe, with a market capitalization of $430 billion from nearly 400 issuers. This makes emerging markets high yield roughly 35% the size by market capitalization and 45% the size by issuer count compared to the broad U.S. high yield index.
In addition to the significant diversification benefits emerging markets high-yield bonds can provide to a U.S. high yield portfolio, it may also provide an attractive alternative or complement to an emerging markets equity exposure, having outperformed over 3-, 5- and 10-year periods as of June 30, 2018 on a risk-adjusted basis, based on Sharpe ratio.2
Investors can access high yield corporate emerging markets bonds with VanEck Vectors® Emerging Markets High Yield Bond ETF (HYEM®), which received an overall four-star rating based on risk-adjusted total return out of 221 funds in the Morningstar emerging markets bonds category and ranked in the 16thpercentile in its category based on 5-year total return, as of June 30, 2018.3
1Source: ICE Data Indices, LLC. Rating is a proprietary composite of various rating agencies. This composite is not intended to be a credit opinion. Investment grade bonds are rated AAA to BBB (high to medium credit quality). Below-investment grade bonds have credit ratings of BB, B, and CCC, and have lower credit quality.
2Sharpe ratio is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
3Morningstar ratings: ©Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating™ based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund's monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics. As of June 30, 2018, HYEM was rated against 221 and 155 emerging markets bond funds over the last three- and five-years, respectively. HYEM received a Morningstar Rating of 4 stars for the 3-year, 5-year, and overall rating. Past performance is no guarantee of future results.
Source for all data: ICE Data Indices, LLC as of June 30, 2018 or as otherwise noted. Emerging markets high yield corporate is represented by the ICE BofAML Diversified High Yield US Emerging Markets Corporate Plus Index. U.S. high yield corporate is represented by the ICE BofAML US High Yield Index.
ICE BofAML Diversified High Yield US Emerging Markets Corporate Plus Index (EMLH) is comprised of U.S. dollar-denominated bonds issued by non-sovereign emerging markets issuers that are rated below investment grade and that are issued in the major domestic and Eurobond markets.
ICE BofAML U.S. High Yield Index: tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion.
ICE Data Indices, LLC and its affiliates ("ICE Data") indices and related information, the name "ICE Data", and related trademarks, are intellectual property licensed from ICE Data, and may not be copied, used, or distributed without ICE Data's prior written approval. The licensee's products have not been passed on as to their legality or suitability, and are not regulated, issued, endorsed, sold, guaranteed, or promoted by ICE Data. ICE Data MAKES NO WARRANTIES AND BEARS NO LIABILITY WITH RESPECT TO THE INDICES, ANY RELATED INFORMATION, ITS TRADEMARKS, OR THE PRODUCT(S) (INCLUDING WITHOUT LIMITATION, THEIR QUALITY, ACCURACY, SUITABILITY AND/OR COMPLETENESS).
The indices listed are unmanaged indices and do not reflect the payment of transaction costs, advisory fees, or expenses that are associated with an investment in any underlying exchange-traded funds. Certain indices may take into account withholding taxes. Index performance is not illustrative of fund performance. Indices are not securities in which an investment can be made. An investment in the VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) may be subject to risks which include, among others, credit risk, call risk, and interest rate risk, all of which may adversely affect the Fund. High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities. International investing involves additional risks which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity and political instability. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability. The Fund's assets may be concentrated in a particular sector or region and may be subject to more risk than investments in a diverse group of sectors or regions.
Diversification does not assure a profit or protect against a loss. Debt securities carry interest rate and credit risk. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. Credit risk is the risk of loss on an investment due to the deterioration of an issuer's financial health. Securities may be subject to call risk, which may result in having to reinvest the proceeds at lower interest rates, resulting in a decline in income. International investing involves additional risks which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity and political instability. Changes in currency exchange rates may negatively impact a fund's return. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability.
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