- Insurance investment into emerging market debt remains low despite yield potential
- Credit quality among emerging market (EM) issuers is improving and default rates are at historic lows
- Investment-grade issuance is a logical area to allocate to under Solvency II’s standard formula
Rapid economic progress has blurred the boundaries between emerging and developed economies. It’s true that emerging debt markets have evolved in the last forty years and credit ratings and default rates have made significant progress. However, European insurance investors still have limited exposure to sovereign or corporate debt from emerging markets issuers.
While some regard Solvency II as the enemy of emerging debt, the regulation is ultimately straightforward in its treatment of all fixed income assets (regardless of provenance). Per Solvency II, if hedged into local currency, an EM bond will consume no more capital than a domestic issue with an equivalent rating.
With European insurance assets under management topping €5 trillion, estimated allocations to emerging markets still stand at a modest 5%. This is a marginal increase from before the implementation of Solvency II at the start of 2016. The outlook for European credit yields is negative and investors are beginning to crowd private credit assets. These conditions may shine a light on the merits of emerging market debt (EMD) allocations.
Back to EM basics
When more than $12 trillion of the global bond market offers negative yields, it is easy to understand the appeal of EMD .
The biggest risk that investors take with EMD is default risk. However, there are others. Commodity-price risk is a common factor among many developing nations. Investors are exposed to regulatory risks, from tax changes to capital controls. EMD issuance in euros is negligible, and so insurance investors in foreign-currency-denominated bonds must factor currency risk into their Solvency Capital Requirement calculations. Hedging investments in bonds issued in local currency is potentially challenging, too. Therefore, we constrain the universe of opportunities for insurance investors below to US-denominated (or hard-currency) debt.
The cost of hedging US-denominated debt for euro-denominated insurers – as measured by the cross-currency basis – has improved in recent years. However, compensation is required to deliver a return on capital comparable with the equivalent locally denominated bond. This can come in the form of yield or diversification. Insurers in the UK benefit from a better cross-currency basis, making hedging EMD issues more appealing.
Fortunately for European insurers, EM bonds offer attractive yields. Expected returns are higher than bonds in developed markets, even for bonds of the same credit rating. They offer diversification benefits to global investors, exposing them to different political, economic and market risks. This market is also growing, with credit far outpacing the issuance of sovereign debt over the past decade.
Sovereign or corporate?
EMD now represents more than 25% of total outstanding global debt, according to data from the Bank of International Settlement. So investors are becoming more aware of the disparities within the asset class.
Hard-currency-denominated sovereign EMD (predominantly US dollar) is often the first port of call for investors. This can be attributed to the long history of issuance in this segment of the market. Although the hard-currency asset class was bigger than the local-currency universe back in 2000, it is now the smallest segment of EMD. The last decade has seen a resurgence in bonds from issuers who have previously benefited from World Bank or International Money Fund assistance. Many of these issuers are now starting to issue their first international bonds. In fact, the size of the investible EMD universe has more than doubled in this time (Chart 1).
Chart 1: The size of the investible universe in EMD has more than doubled since 2007
Source: JP Morgan, as of 31 July 2020
Hard-currency-denominated corporate bonds represent a large investable asset class and a logical point of entry for European insurance investors. At approximately $2 trillion, the asset class is larger than US High Yield ($1.5 trillion), and almost double the size of the hard-currency-denominated sovereign EMD class. In fact, in each year since 2003, EM corporate debt issuance has outpaced that of EM sovereign debt (Chart 2). The EM corporate bond market offers significant opportunities for security selection. There is an information gap in this market. Companies constrained by their sovereign rating and stale ratings on smaller issuers may not match improving fundamentals. Contrary to popular belief, the EM corporate market offers the most diversification across the major EM bond indices – 659 issuers across 52 different countries across several regions (Chart 3). The diversity across issuers has grown over the past decade. EM corporate bonds are now the most diverse set of issuers within EMD.
Chart 2: Growth in EM corporate debt issuance
Source: JP Morgan, as of 31 July 2020
Chart 3: EM corporate bonds by region
Source: JP Morgan, as of 31 July 2020. For Illustrative purposes only.
Quality: myths and reality
Insurance investors may subscribe to the notion that EM bonds are of a lower credit quality than developed market debt. This is especially true of investors contemplating how an EMD strategy might interact with a Solvency II balance sheet.
In reality, over the past five years, EM companies have worked reduced borrowing and improved credit quality. On the other hand, equivalent US investment-grade companies, which are currently in more debt than they have been in any of the last fifteen years. Default rates stand at historic lows over the last twenty years for EM. This is because today a greater proportion of debt is issued in local currency, which reduces dependency on exchange-rate moves.
A challenge for insurers arrives in the form of credit agency ratings of EM credit. Ratings agencies naturally place a more stringent focus on companies in developing countries than on those in the developed world. They usually employ a cap on ratings that is equivalent to that of the sovereign rating of the country in which the company is based. EM companies will often have stronger credit fundamentals than their developed-world counterparts in the same credit-rating category.
Without the rules of the Solvency II and its standard formula framework, institutional investors operating outside of the insurance rules – or those taking advantage of internal models – could see beyond rating agency opinion. These investors could identify companies with solid balance sheets, strong strategic positions, large market shares and strong shareholders that are not adequately represented by rating agency opinion. For insurance companies using the European Insurance and Occupational Pensions Authority (EIOPA) standard formula that are unable to apply alternative assessments of an issue’s true quality, a logical area of focus is on investment-grade issuance. Investment-grade credit represents 76% of the JP Morgan GBI-EM Global Diversified Index, as of July 2019.
Look past credit quality preconceptions and there is a rich and growing seam of high-quality, highly rated, strongly performing companies out there. These companies can help investors to build exposure as part of a well-diversified balance sheet.
Environmental, social and governance (ESG)
Today’s investors are aware of and concerned about climate change and social disparities. Myths about ESG standards in emerging market countries have acted as a barrier to European insurance investment, given EIOPA’s growing focus on sustainability factors.
ASI has developed a proprietary ESG framework that also factors in a fourth dimension – political risk. Our ESGP approach draws together our bottom-up, research-led investment expertise with independently sourced quantitative measures on each of the four factors. It also accounts for the direction of travel in these rapidly developing economies. Dialogues with governments about driving more sustainable and inclusive reform agendas significantly help inform this analysis.
ASI began managing EMD assets in 1994. Today, we have a team of more than 40 people and our fundamental analysis spans sovereign and corporate bonds, external and domestic debt and foreign exchange. Our team is able to structure bespoke EMD mandates for insurance clients across Europe and offers a range of pooled fund strategies. To discuss how EMD could be relevant to your insurance company balance sheet, contact your local ASI representative.