Emerging market corporate bonds tend to have a higher Sharpe ratio and higher credit ratings than sovereign bonds. What might this mean for those considering an EM allocation?

By Warren Hyland, Portfolio Manager at Muzinich & Co.

For investors looking for diversification and exposure to the economies of Asia, Latin America, Eastern Europe and the Middle East, an allocation to the emerging market (EM) hard currency sovereign universe may be the obvious choice.

It provides exposure to over 50 countries at different stages of economic development, and lower volatility due to the lower currency risk.

However, we believe the EM hard currency corporate universe is a more attractive asset class than its sovereign counterpart. It is a multi-asset global opportunity set, providing investors the ability to rotate into different regions, sectors and sub-asset classes.

Corporates offer additional benefits

The corporate universe also offers additional benefits compared to the sovereign market. Equities are lower down the capital structure, and local currency bonds are hurt by currency fluctuations. Both are therefore more volatile, which reduces their Sharpe ratio.

Unlike developed market bonds, EM assets are not separated into investment grade and high yield (i.e., they do not have unique indices). Therefore, investors do not have to rotate their allocation over the economic cycle during periods where high yield or investment grade do better. US Treasury rallies are also already priced into EM corporates, unlike asset classes such as U.S. high yield.

A look at the underlying components of the corporate and sovereign markets also explains why the corporate segment is potentially more attractive. Sovereigns have a larger distressed bucket and more duration risk than corporates, yet the yields are similar. Therefore, sovereign investors are not being compensated for the additional duration and credit risk.

Higher return with lower volatility

To get the same EM exposure, investors only take half the beta by allocating to the corporate market. This is also played out in the total return of both asset classes. EM corporates have generally performed better over five years because of their lower beta during periods of market volatility.

Investors are potentially paid a higher return with lower volatility for choosing corporate risk over the sovereign. Therefore, in our view, there is little rationale to owning sovereigns.

Strong Fundamentals

EM corporates are also in a strong position from a fundamental perspective. The reopening of economies following Covid-19 has led to a huge increase in economic growth. Higher volumes and stronger prices have resulted in greater revenue streams. Corporate leverage is expected to return to levels not seen since 2011 and this is likely to result in an increase in rising stars. The opposite is true in the sovereign space.

While EM sovereigns may be the more familiar asset class, we believe there is a stronger case for owning EM corporates. As noted herein, they have a higher Sharpe ratio, are less volatile, have a lower beta, are higher ratings and have benefitted from the post-pandemic recovery. As a result, EM corporates offer a compelling investment opportunity in our view.

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Warren Hyland has been a portfolio manager for emerging markets at Muzinich & Co. since 2013. He has more than 20 years of corporate credit experience. Warren has a BSc in Mathematics for Business from the Middlesex University London, and later received his MSc in Shipping Trade and Finance from the CASS Business School. He holds the Chartered Financial Analyst designation.

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