2024-01-19 23:23:26 ET
Summary
- CEMB is an ETF that tracks the performance of US dollar-denominated bonds issued by emerging market corporate entities.
- Emerging market corporate bonds have had superior risk-adjusted returns compared to US corporate bonds and emerging market sovereign bonds over the past 10 years.
- Higher economic growth in emerging markets in 2024 is expected to benefit companies with outstanding debt, leading to increased profits and lower default probabilities.
iShares JP Morgan EM Corporate Bond ETF (CEMB), is a passively managed fund associated with the JPM CEMBI Broad Diversified Core Index which "tracks the performance of US dollar-denominated bonds issued by emerging market corporate entities''. Investing in emerging market corporate bonds is an area many are not experienced in, and thus are not aware that the asset class had superior risk-adjusted returns compared to U.S. corporate bonds and emerging market sovereign bonds over the last 10 years ending June 30th 2023. This, combined with the fact that emerging market economic growth is expected to be much higher than that of developed market economies in 2024, highlights an opportunity in emerging market bonds. Higher growth in these economies should benefit those companies with outstanding debt, increase their profits and lower their probability of default. Overall, this will allow investors to take advantage of the higher coupon rates these companies must offer, while also receiving capital appreciation as potentially lower credit spreads raise the price of these bonds. CEMB, one of few ETFs specifically dedicated to emerging market investment-grade corporate bonds, is positioned to take advantage of these future developments, and should be a welcome addition to investors looking to add diversification and increased risk-adjusted returns to their portfolio. As such, we rate CEMB a "Buy" for EM corporate bond investors.
Emerging Market Corporate Bonds: A Much Overlooked Allocation
Venturing into the waters of emerging markets is uncomfortable for many investors, as they either lack experience and/or have a bias toward investing in their home countries, where they understand the language and culture, and thus can more easily feel secure with the investments they are making. We can see this phenomenon in the chart below, comparing investors' equity allocations to their home country versus that country's weighting in the MSCI ACWI.
Still, this bias has largely not been a problem for U.S. investors. Despite International Developed and Emerging market equity indexes being undervalued for years, their returns have trailed the U.S. equity indexes. Knowing this, investors may be even less interested in foreign fixed income, as they assume this trend will continue. Additionally, the numerous stories of emerging market defaults over the years in countries like Argentina understandably contributes to the hesitation.
However, when digging into the data, it can be seen that this apprehension has been misplaced when it comes to fixed income. The chart below shows that emerging market investment-grade corporate debt has actually had superior-risk adjusted returns versus investment-grade U.S. debt.
In our experience, U.S. corporate bonds are often the topic of conversation over EM corporate bonds. However, observing the figures above, it appears to us that they should be given more consideration as clearly they can add significant value to a portfolio.
Tailwinds for EM Corporates
Emerging and developing markets are expected to see significantly higher economic growth than more mature economies in 2024. The Conference Board, a non-profit business research group, is predicting that emerging market economies will see economic growth of 3.8% compared to only 1% for mature economies this year. This predicted differential of 2.8% is significantly higher than the average growth differential seen from 2020 to 2023 of 1.7%.
The disparity in growth forecasts should be seen as a sign that emerging market debt will continue to have the ability to maintain its lower number of corporate defaults as seen in 2023 compared to the US and Europe. A higher growth rate infers that EM companies will experience faster growing revenues which will enable them to service their debt. This means that a fund like CEMB will be more likely to deliver on its 4.69% average weighted coupon. This figure is nearly 1% higher than the 3.75% coupon for the iShares 1-5 Year Investment Grade Corporate Bond ETF ( IGSB ), which invests in U.S.-only corporate bonds. Additionally, stronger company performance should lead to credit upgrades, lower spreads and better capital appreciation.
Risks
Some of the risks when investing in EM Corporate Bonds include:
1. Default Risk - When investing in any corporate bond there is always a risk that companies default on their debt, lowering their returns. One way to mitigate this is to buy credit default swaps on a particular name in the portfolio of a fund that you think may default or face a credit downgrade. However, one would have to closely scrutinize the credit fundamentals of each company.
2. Rising Rates - Rising interest rates will hurt the return of any bond portfolio. Buying interest rate swaps or decreasing the duration of the bond portfolio are two ways to mitigate this.
3. Geopolitical Risks - Emerging markets are more likely to face geopolitical events that can send a country into turmoil and damage the economy, thus increasing the likelihood that businesses are unable to make their debt payments. These types of events can be very difficult or impossible to predict so diversifying the portfolio geographically, as CEMB does, can greatly reduce the risk that any one event will erode overall returns. Although the fund has a large weighting to China, this is not unreasonable given its relatively larger global economy.
4. Foreign Exchange Risk - As CEMB invests in U.S. dollar-denominated bonds, there is no direct forex risk to U.S. investors.
Our "Buy" Case for CEMB
As stated earlier, CEMB is one of the few ETF's dedicated to corporate investment-grade U.S. dollar-denominated emerging market bonds. The WisdomTree Emerging Markets Corporate Bond Fund ( EMCB ) is the only competitor we could find that has also been around for 10+ years. CEMB achieved a 3.09% annualized return over this time period, versus 2.84% for EMCB, despite the fact that EMCB is actively managed, and boasts a minimal expense ratio of 0.6%, 10 bps higher than CEMB's. CEMB has also achieved these higher returns with lower risk, with a standard deviation over this span of 7% versus 7.6% for EMCB. All of this, combined with the fact that CEMB's assets are nearly 10x higher than EMCB's, thus providing more liquidity, indicates clearly to us that CEMB is the smartest choice for investing in this asset class.
For further details see:
CEMB: Invest In An Overlooked Asset Class - Emerging Market Corporate Bonds