Why Retirement Plan Sponsors Shouldn’t Overlook Emerging Market Corporate Bonds

Unprecedented policy support in 2020 from the world’s central banks and governments in response to the Covid-19 pandemic helped stabilize markets, supported a resumption of economic activity, and contributed to a historic decline of bond yields. Thus far in 2021, concerns that demand-focused fiscal stimulus may lead to overheated economies has pushed up bond yields. However, while rates have lifted out of their 2020 ranges, high levels of government debt across developed markets (DMs) paired with systemically low inflation are likely to prolong the low-rate environment. Persistently depressed bond yields and heightened interest rate volatility create difficult challenges for many investors, but especially for retirement plan sponsors looking to maintain portfolio balance as they invest capital in today’s conditions.

For many retirement plans, emerging market (EM) debt isn’t a new investment allocation. However, many plan sponsors continue to view EM corporate debt as a market dominated by sovereign risk premia. While that may have been true when many plans were first adding EM debt to their benchmarks, this market has grown to more than $2.6 trillion1 and it now features qualities that can help plans meet current challenges to their fixed income portfolios via several potential implementations.

Evolution of the EM corporate debt market

When we launched our Emerging Market Corporate Bond Strategy in 2002, we had no EM corporate index against which to benchmark it, and the corporate market was little more than $200 billion. In 2007, when JPMorgan debuted its Corporate Emerging Market Bond Index (CEMBI), the market had grown to over $500 billion, still only half the size of the external sovereign market. At the time, EM corporate debt was viewed as an add-on investment for sovereign EM debt portfolios, typically in off-benchmark positions in the fastest-expanding component of the EM debt market. But its growth, which was -- and still is -- touted as part of the investment rationale, has pushed EM corporate debt to over $2.6 trillion, nearly twice the size of the external EM sovereign and US high-yield markets.

The EM corporate debt market’s expansion has been broad-based, as the number of countries within the CEMBI index universe has gone from 32 to 60, with nearly 800 distinct issuers1. This galloping growth of EM corporate debt and its investor base has given smaller issuers access to capital markets. But the market has also maintained its quality: Investment-grade securities still make up nearly 60% of the investable universe1.

EM debt within plan benchmarks

For many retirement plans, EM debt isn’t a new allocation because a majority of plan sponsors have an EM debt allocation within their fixed income benchmark. However, how this majority implements those allocations still reflects market conditions at the time of the initial allocation. Looking at a sample of 20 US-based public plans, only two contain any formal inclusion of EM corporate debt (at 25% and 5%, respectively). Of the remaining 18 plans, nine are benchmarked against an external sovereign debt index, four are benchmarked to a local currency sovereign benchmark, and five are benchmarked to a blend of external and local currency sovereigns.

These plans typically have US dollar liabilities, and yet many have decided to hold EM assets issued in local currencies. Presumably, plans that have formally allocated to local currency EM debt were drawn by attractive carry and the notion that an accumulation of wealth in EMs would lead to stronger currencies over time. Unfortunately, while EM economies have increased their share of global GDP, that hasn’t translated to stronger currencies across the board. In reality, foreign exchange markets have been the quickest to react to shifts in macroeconomic uncertainty as well as to idiosyncratic risks within EMs. As a result, local currency EM debt has added little to fixed income portfolio returns while adding material levels of volatility.

EM Corporate Debt Has Generated Strong Risk-Adjusted Returns

Annualized Returns and Volatility Since 2010

Source: J.P. Morgan, Bloomberg Barclays and PineBridge Investments as of 31 March 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change. Past performance is not indicative of future results.

Investors in US dollar-denominated EM debt have had a more stable experience, but as evidenced above, they could have enhanced their risk-adjusted returns with a dedicated allocation to EM corporate debt.

While EM corporate debt can enhance existing EM debt allocations, we have also seen an increasing trend among plans that are evaluating EM corporate debt as a way of enhancing existing DM corporate credit allocations. Here we also find support from past experience because investment-grade EM corporate debt has historically delivered higher returns than investment-grade US corporate debt, with lower volatility.

Certainly, historical return data make a compelling argument for including EM corporate debt in either an EM debt or corporate debt allocation. Evaluating relative value, diversification benefits, and the potential risk versus plan benchmarks requires closer examination.

Relative value comparisons – more than meets the eye

The role of fixed income, broadly speaking, in a retirement plan portfolio is to preserve capital and generate income. While unforeseen factors may cause realized performance to differ from expectations, yield levels typically serve as a good barometer for investors when weighing various investments’ potential income.

Comparing yield to worst between the EMBI Global Diversified (sovereign) and CEMBI Broad Diversified (corporate) indexes, investors would be forgiven for doubting the relative value that an EM corporate debt allocation can make to a portfolio with an external EM sovereign benchmark. As one might expect, investment grade EM corporate debt has delivered a consistent premium over investment grade US corporate debt. However, in this context, index yields alone suggest that perhaps EM corporate debt is perhaps less attractive today relative the historical yield pick-up over US corporate debt.

When comparing the two external EM debt markets, although JPMorgan manages both indices, defaulted securities remain in the EMBI Global Diversified index, but they’re removed from the corporate CEMBI Broad Diversified index. That difference hasn’t always resulted in a material mismatch in valuation, but the recent defaults of Argentina and Lebanon are currently contributing 110 basis points of yield to the sovereign index. Excluding those two, the yield to worst of the EMBI Global Diversified is 4.16%, compared to 3.85% for the CEMBI Broad Diversified.

Duration is another factor that distorts relative value comparisons between EM corporate, EM sovereign, and US corporate debt. EM corporate debt has historically been a shorter-duration asset class than either EM sovereign or US corporate debt, and the recent extension of duration in both EM sovereign and US corporate markets has further altered the relative value landscape.

EM corporate debt provides diversification

In the year-plus since governments and central banks launched their first policy responses to the Covid-pandemic and related lockdowns, helping soften the global recession’s impact, markets have turned their focus to the post-Covid economic recovery. Nowhere has that focus been more acute than in the US, where extraordinary fiscal packages are causing upward revisions to GDP and inflation forecasts, and raising concern that the Federal Reserve’s monetary policy may need to shift accordingly.

Plan sponsors are likely to find themselves caught between a rock (systemically low rates) and a hard place (heightened interest rate volatility) when making decisions for their fixed income portfolios. EM corporate debt’s resilience in the face of rising rates was on full display in the first quarter of 2021, outperforming both EM sovereign and US corporate debt in both total and excess returns.

Q1 2021 Total and Excess Returns: EM Corporate, EM Sovereign, EM Corporate IG and US Corporate

Source: JP Morgan, Bloomberg Barclays and PineBridge Investments as 31 March 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change.

The resilience of EM corporate credit spreads can be partly attributed to a relative lack of duration selling. But EM corporate debt also benefits from regional technical support that has been a major contributor to the asset class’s relatively low volatility over the longer term. Asian issuers account for roughly half of the EM corporate debt universe by market value, and those securities benefit from strong demand from a very well capitalized local investor base. In fact, some estimates show that Asian investors hold roughly 80% of Asian corporate bonds2, which provides stability in periods of global market stress. By comparison, Asia represents less than 20% of the EM sovereign market and just 0.60% of the US corporate index3.

Regional Distribution of EM Corporate, EM Sovereign and US Corporate Debt (MV %)

Source: J.P. Morgan, Bloomberg Barclays and PineBridge Investments as of 31 March 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

Implementation of EM corporate debt

Plan sponsors looking to take advantage of all the benefits EM corporate debt can offer, particularly amid current market conditions, will likely need to make the initial investment as an off-benchmark allocation. As we’ve highlighted in the comparisons above, the decision typically comes as an allocation within an existing EM debt or US corporate credit allocation. So it’s important to understand the impact such an allocation can have, not only on total return and volatility but also on tracking error to the plan benchmark.

Annualized Return and Volatility, Correlation and Tracking Error

EM Corporate, EM Sovereign, EM Corporate IG, US Corporate and Hypothetical Blend Allocations

Source: J.P. Morgan, Bloomberg Barclays and PineBridge Investments as of 31 March 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

Plan sponsors should have confidence that an off-benchmark allocation to EM corporate debt from either portfolio allocation – EM debt or US corporate – will enhance returns and reduce volatility with only a limited increase in tracking error relative to the plan benchmark. Certainly, while analysis suggests such a decision should be simple, of course we know that any off-benchmark decision comes with a heightened sensitivity to market risks. Which is why we believe it’s important that retirement plans looking to make an initial off-benchmark allocation to EM corporate debt identify a manager that can partner with them to create an optimal investment solution – and deliver not only alpha but consistent service, along with transparency regarding market risks and opportunities.