Emerging Market Corporates: Managing Liquidity in a Constantly Evolving Environment

Authors:
Steve Cook
Co-Head of Emerging Markets Fixed Income
London

Chris Perryman
Senior Vice President
Corporate Portfolio Manager and Head of Trading, Emerging Markets Fixed Income

John Bates
Head of EM Corporate Research
Emerging Markets Fixed Income

27 January 2017

Transformational forces have reshaped fixed income markets since the global financial crisis. These include banking sector consolidation, advancing technologies, and the evolution of new regulations. As investment banks have been relegated to primarily broking roles, fixed income investors, particularly in emerging markets (EM), have seen a decline in what these banks are able to offer in terms of investment research, capacity across EM regions, and crucially, bond market liquidity.

As in all fixed income markets, secondary market liquidity is not abundant in EM. The decline in market liquidity means that investors who take too short term a view can end up being “topped and tailed” (i.e., selling out too soon or buying too late) when volatility increases. A longer term investment horizon, plus strong liquidity management, is key.

Today’s EM corporate bond market

The total EM corporate US dollar universe has grown from $548 billion at the end of 2007 to $1.8 trillion now, and the number of individual issuers in the most broadly used benchmark, the JP Morgan CEMBI Broad Diversified index, has increased to 541 corporate issuers from just 206 in 2007 and to 50 countries from 34 over the same period. This market is diverse and varies in credit quality, with outstanding securities across the AA to CCC rating categories.

EM Corporate Bond Market Evolution

Emerging Market Corporate Bond Market Evolution

Source: JP Morgan, as of December 2016. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The EM corporate asset class is now a significant component of global fixed income and offers several potential advantages to investors. These include much lower volatility than historically perceived and low sensitivity to US Treasuries. EM corporate bonds also tend to have shorter duration and higher yields and spreads versus comparable developed market fixed income securities. While one would assume that a much larger and growing market would result in better trading liquidity, this has not been the case. This is because more long-term “buy and hold” type investors have entered the market, and overall institutional investors are estimated to form 80% of the total investor base.

Investment banks’ role has changed

Before the crisis, investment banks could obtain funding at very low rates, so any proprietary position or inventory their trading desks held naturally incurred positive carry/income. The largest investment banks enjoyed their position as the primary liquidity providers to the secondary market and were also often among the largest holders and investors in the various fixed income markets.

In today’s fixed income markets, the risk-taking ability of investment banks has diminished, and regulations have been established to reinforce the safety of the securities markets. Many feel these measures have actually resulted in the opposite effect and made markets even more volatile. Indeed, we have seen pricing levels move materially by relatively modest trading volumes.

More Countries, Less Concentration

Source: JPM EMBI Index Monitor, as of December 2016. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Compounding the liquidity issue, investment banks often are unwilling to bid (or offer) in certain sectors or countries during periods of heightened volatility. So EM fixed income investors need to remember that, however good the underlying fundamentals of an individual name, they will experience periods when the market simply becomes untradeable.

Another major challenge now is the fragmentation, rather than the actual amount or level, of liquidity. Most banks have materially diminished balance sheets since the crisis and are focusing on more niche areas of the market. As a result, they have less scope to trade and provide liquidity across the full EM spectrum.

Finally, regulations continue to evolve, and we expect more to come. The fallout from Basel III and the Markets in Financial Instruments Directive II (MiFID II) – which seek to protect banks from having unsustainable risk profiles and regulate the flow of information to clients – will also cause investment banks to be less active in market-making and providing liquidity.

E-trading platforms to the rescue?

Electronic trading platforms have sprung up to try to capitalize on the weaker position of investment banks and in the face of upcoming regulation changes. There are currently approximately 113 of these fixed income trading platforms, illustrating the scale of the challenge the banking industry faces.

However, because they are RFQ (request-for-quote) in style, most of these platforms are of little help in the EM fixed income space due to the relatively lower number of bonds in circulation in this market. Meanwhile, a handful of platforms try to show the available liquidity in EM by using closed order books. While this process is still in development, it is helpful in ensuring that investors can see what liquidity is available. This is especially true with “dark pools,” where investors can trade illiquid names with minimal market impact.

Yet, despite this plethora of platforms, the reality is that investors/asset managers will be unable to accommodate multiple platforms on their desktops. Therefore, we expect to see a marked consolidation of these platforms over time. Eventually, however, these platforms may be able to reduce fragmentation, enhancing market efficiency. We also expect bids/ offers to improve (i.e. tighten) as the markets visibility becomes clearer, which should lead to better overall market liquidity.

Managing the risks

The good news is that tighter liquidity has come hand-in-hand with steadily declining volatility since the global financial crisis. One of the primary drivers of this is the investor base, which now consists predominantly of institutional investors. The bulk of the $1.8 trillion in EM corporate bonds is held by investors who are typically viewing the asset class as a strategic rather than a tactical allocation. Consequently, when the market endures periods of heightened volatility, these longer term investors are much less likely to panic sell and are more likely to stick with their core allocations – a key lesson for any investor in this market.

Number of Issuers and Issues Has Materially Increased Overtime

Source: JP Morgan EMBI Monitor, as of December 2016. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

And while volatility may be declining, we think many investors can improve risk management by increasing their portfolio diversification. Through our analysis and experience, we believe that a mix of 100-120 names (versus 500-plus in the index) provides an optimal exposure to the most compelling areas of the market, including countries, sectors, and rating categories. However, it is possible to have too much of a good thing. For instance, if a specific industry sector in a particular country has five investment grade rated issuers, having exposure to all five names is unlikely to enhance an investor’s overall return because performance between those names is likely to be heavily correlated.

While today’s market liquidity issues are prevalent across global fixed income, they are more acute in EM corporates. So investors must obtain the necessary research and support to gain a high level of conviction in holding these assets through such volatility.