Reaching for yield: the reshaping of the EM corporate debt market

The massive universe of negative-yielding bonds hit a new milestone earlier this month. On the backs of central banks around the world tilting dovish, the value of this debt surged higher to an eye-watering $12.5tn — a level not seen since 2016.

Risk assets have simultaneously rallied, accelerating a well-known dynamic that has come to characterise the post-financial crisis decade: the reach for yield.

It is this phenomenon that's helped to turbocharge both the US junk bond market and the leveraged loan market, helping them to become $1tn asset classes stateside, according to S&P Global. This phenomenon can also take credit for the growing popularity of illiquid assets and Japanese investors increasing their holdings of unhedged foreign bonds, despite the risks should FX rates move against them.

A new paper by Columbia University's Charles Calomiris, and a team of academics, traces how this hunger for yield has helped to propel the growth of another asset class: emerging market (EM) corporate debt. More specifically, dollar-denominated bonds issued by EM corporates with a face value of $500m or more.

Prior to 2008, the research found that these $500m bonds represented just 33 per cent of the total value of bonds issued in the eight years up to 2008. Between 2009 and 2016, the share of $500m-plus bonds doubled to 62 per cent.

In terms of the total number of bonds, dollar debt of this size issued by EM corporates comprised just 11 per cent before the crisis and grew to 32 per cent after. Smaller issuances — below $300m — lost favour, with their share falling from 75 per cent pre-2008 to just 48 per cent post-2008.

Here are two charts from Calomiris et al. depicting the relative growth of this asset class versus smaller-sized dollar-denominated EM corporate debt. In the five years after the 2008 crisis, the value of those larger-sized bond issuances increased by 380 per cent:

Calomiris told Alphaville he attributes the dip between 2013 and 2015 to the surge in volatility that came after the Fed hinted it would soon start winding down its purchases of treasury and agency bonds. The aptly-named Taper Tantrum roiled emerging markets, leading to massive capital flight. As the tick-up in 2016 indicates, this event was not a turning point, but just a temporary dislocation. For this reason, Calomiris said he expects the trend to have continued since then.

So what explains the enthusiasm for EM corporate dollar debt with a face value of $500m specifically?

That threshold is an important one because it's the minimum size that is included in market indices, namely JPMorgan's EMBI Global Diversified Index for sovereign bonds, and the firm's corresponding CEMBI Narrow Diversified Index for corporate bonds. JPMorgan also has another index for corporate bonds that has a lower threshold of $300m.

Both international investors and emerging market businesses benefited from this.

First, investors without much experience making bets in emerging markets had a direct channel through which they could increase their exposure to higher-yielding debt with less downside risk. For one, instruments included in indices tend to have more liquidity compared to the underlying assets — meaning they are less sensitive to flows of capital in and out of the investment vehicles.

What Calomiris and his colleagues noticed is that it was these “crossover” funds, who tended to manage broad portfolios with a greater emphasis on debt from developed markets prior to the crisis, that had the strongest appetite for dollar denominated EM corporate bonds following 2008. Funds that already specialised in this corner of the debt market, unsurprisingly, didn't see as dramatic a shift in their holdings. Indeed, these firms appeared more willing and able to fund smaller, riskier EM firms where the gains were potentially larger.

As the graphics above make clear, emerging market businesses were more than happy to satisfy this nascent demand from crossover funds. This chart emphasises the high correlation (0.93) between mutual fund inflows in to EM debt and the number of $500m bonds reiterates the point:

Moreover, the “stunning” result, as Calomiris put it to Alphaville, is that it wasn't just the large firms that issued these $500m bonds. Here's what he says they found instead (emphasis ours):

For firms that were on the small side in terms of asset size, many that would not have dreamt of issuing a $500m corporate bond were now issuing it. And two years after they issued those bonds, they were still holding 80 per cent of the proceeds in cash.

The reason why smaller-sized EM firms were willing to upsize their bond offerings is because it allowed them to save on financing costs. From the paper:

For example, when issuing $500 million bonds instead of $400 million bonds, emerging market corporates paid about 100 basis points less after the GFC than the differential they paid prior to 2008. In other words, the size yield discount increased substantially after 2008.

Moreover, the companies that were more inclined to hold excess, lower-yielding cash tended to be domiciled in places where interest rates were higher.

What makes this paper all the more relevant is where we are in the current cycle. Global growth is slowing and economic indicators are flashing red. This means the propensity to reach for yield may soon be losing favour among investors — and with that, the asset classes that once benefited most from the post-crisis, zero interest rate zeitgeist.