Aberdeen Standard’s Dahiya: Emerging market corporate defaults - rising but manageable

The ongoing Covid pandemic has severely impacted economic growth and business activity throughout the world. Reduced revenues and profits have made debt servicing more challenging for more companies. This is reflected in more distressed credits and rising corporate default rates.

Emerging market (EM) corporate debt has not been immune to this trend. However, we think concerns that emerging market debt issuers might be particularly exposed in this respect are misplaced. On the contrary, historically the EM corporate debt market has actually been relatively resilient to past major crises. This is also evident in default data from pandemic-hit 2020.

2020 default trends

According to Moody’s, a total of 211 rated corporate issuers defaulted in 2020, which was double the 2019 tally of 105. Similar to previous years, most of the 2020 corporate defaults - 141 (or two-thirds of the total) occurred in America, followed by 38 defaults in Europe (18 per cent of the total). Corporate defaults in Asia-Pacific (17), Latin America (13) and Middle East & Africa (two) amounted to 32 or just 15 per cent of the total in 2020.

If we look more specifically at the high yield segment of the market, default rates were only 2.7 per cent in the EM corporate benchmark (JPM CEMBI) compared to 22 per cent in the EM sovereign benchmark (JPM EMBI) and 6.8 per cent in the US high yield benchmark. The lower default rate in EM corporate high yield companies compared to US high yield companies has been a persistent trend since 2015.

Looking ahead, despite the continuing negative impact of the pandemic, we think there are some good reasons why EM corporate’s relative resilience should be sustained in 2021 and beyond.

Modest and manageable debt levels

First and perhaps foremost, a key factor to note is that EM corporate debt levels remain comparatively modest. One key measure of this is net leverage, which compares the total debt level to annual earnings. As shown below, at end-2020, this ratio was x1.4 for EM corporates – well below the x1.7 for US high yield debt and less than half of the x2.9 for global investment grade corporates.

Relatively low exposure to highly pandemic-hit sectors

Secondly, while the pandemic has affected most companies, the negative impact has been particularly concentrated in some sectors. Examples of this include airlines, lodging, autos and leisure and retail, which are all parts of the consumer cyclical sector. This broader sector accounted for just 6 per cent of the EM corporate debt market compared to 14 per cent in the US high yield market at the end-2019 and around the onset to the Covid crisis.

A key reason for the smaller share of consumer cyclical companies in the EM corporate debt universe is that many companies (such as airlines, lodging, etc.) typically generate revenues in local currencies. As such, they tend to have more limited need for US dollar debt.

Currency vulnerabilities worries likely overdone

Thirdly, contrary to a quite widely held assumption, on the whole EM companies’ vulnerability to a strong US dollar is actually quite modest. In particular, the concern here is that dollar strength increases the local currency value of EM companies’ debts and the cost of servicing these debts. Such currency concerns were particularly amplified when pandemic fears were at their highest in 2020. Indeed, in the two months to end-March 2020, the Russian rouble, Mexican peso and Colombian peso plummeted by 26 per cent, 25 per cent and 20 per cent respectively against the US dollar.

However, closer analysis reveals that only a small proportion of EM companies (around 12 per cent of the total bond stock according to JP Morgan) are highly exposed to currency weakness.  A key reason for this is that many EM corporates are in countries with currencies that are either managed or pegged to the US dollar. In addition, many EM companies are naturally protected as they get paid in dollars for their exports. This especially applies to energy and mining sector exporting companies.

Strong economic recoveries mitigating default risks

Finally, it is worth remembering that the overall global economic backdrop should be helpful for mitigating default risks going forward. Data from around the world now suggests clearly that the worst of the pandemic is in the past. Indeed, thanks to ever expanding vaccination programmes, business conditions will normalise, supporting a very strong global economic recovery in 2021.

Furthermore, the global recovery will be led by emerging markets. The IMF expects that ‘emerging and developing Asia’ in particular will grow by +8.3 per cent in 2021, nearly twice the (+4.3 per cent) rate of advanced economies. With EM company revenues and profits expected to rebound very strongly, default risks should also begin to ease.

In summary

The Covid shock has certainly increased default risks right across the global corporate bond spectrum, including EM corporate bonds. This further underscores the importance of credit research and careful stock selection.

However, on the aggregate level, we think there are some structural factors that should help to limit credit risks. This includes EM corporates’ comparatively low debt levels and relatively low exposure to highly pandemic-hit sectors. In addition, potential currency vulnerabilities in the (uncertain) event of US dollar strengthening should be manageable on the whole. Finally, the expected strong global economic recovery should certainly help to mitigate default risks going forward.