EM illiquid credit: opportunities & risks

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Mihai Florian
December 02, 2020

As investors continue their search for ever-elusive yield, illiquid hard-currency loans to emerging-market corporates are gaining interest as a potentially attractive solution with a deep opportunity set.

Events in 2020 have brought uncertainty to global markets but one theme which holds consensus is the view that core rates will remain low for the foreseeable future. In this environment, fixed-income investors will likely continue to face the key challenge of the last 10 years – finding appropriate strategies to enhance the yield in their portfolios.

Since the global financial crisis, some investors have turned to alternative investment strategies, such as private credit, to achieve yield, while others have broadened their geographic reach to include emerging market (EM) assets, focusing primarily on liquid, public-market strategies. Most recently, following the Covid-related market dislocations, there has been a wave of new capital raised anticipating a surge of distressed opportunities in the developed markets (DM) corporate sector.

We believe there is a fourth attractive approach available, which remains largely untapped: performing hard-currency loans to large, healthy EM corporates.

The opportunity

These loans can offer potential advantages for an investor looking to enhance portfolio yield without compromising on robust legal documentation or having to venture into higher leveraged, distressed opportunities.

How do they work?

Through income-paying, drawdown structures, investors have the potential to capitalise on the illiquidity premium the secondary-loan market offers compared to liquid instruments, through high-quality corporate credit in EM countries. These structures have the potential to achieve double-digit returns that, given their longer-term investment horizon, are not susceptible to the shorter-term risk dynamics of potential market volatility and flow fluctuations in the EM asset class.

While the opportunity set is deep, navigating it successfully requires extensive regional and sectoral expertise, as well as experience with the legal and documentation framework of the underlying assets.

4 points on managing risk

As credit investors, we focus first and foremost on downside protection before considering the potential return of an investment. This risk assessment has four main dimensions:

1. Credit risk

Focusing on the underlying borrower or issuer leverage ratio. In the current global environment, with ultra-low rates coupled with the substantial amounts of liquidity and dry powder available, we have seen an increase in both the enterprise value multiple and ability of corporates to service higher levels of indebtedness. This leaves the corporate sector vulnerable, not so much to the changes in the underlying rates (which we expect to remain low for the foreseeable future), but to macro and sectorial shocks.

2. Legal risk

While the rise of covenant-lite documentation is a growing issue in developed markets, EM corporates are still typically borrowing in the international markets (via loans or bonds), largely using full-covenanted documentation. Outside the highest-quality, investment-grade names in EM, most of the corporates are subject to a full set of financial covenants. They also face tight restrictions on asset disposals and value leakages, either via an M&A transaction or dividends payments.

3. Enforcement and restructuring risk

Should an underlying credit deteriorate and subsequently default, creditors will need to ensure their rights are protected and the restructuring or enforcement follows a well-defined process. This allows the creditors to maximise their recovery and ensure a fair and speedy process. Legal environments in DM, especially in the US and UK, have been thoroughly tested for decades and are well understood by market participants. This is less the case in EM, making certain factors such as having the appropriate underlying security package, avoiding certain jurisdictions, mitigating against local factors and having an experienced investment team even more important.

4. ESG risk

We believe investors should view ESG as an alpha opportunity, not just a risk-management tool. Sometimes due to laxer local regulation, we have seen EM corporates more exposed to all three risks within the ESG complex. We believe investors need to rely on an ESG evaluation framework designed to overcome challenges specific to fixed income credit with a focus on value-add engagement and research capabilities.

Moreover, in EM we have seen an inverse relationship between access to capital and ESG adherence – the lower the access to capital, the higher the willingness to engage on ESG matters. In our view, this opens up opportunities for creditors to have a more influential role when engaging with EM borrowers than might be the case in other markets.

Conclusion

In today’s market, characterised by macro-driven volatility, political and economic uncertainty with low core rates, we believe an approach focusing on high-quality performing EM credits in an illiquid loan format offers an attractive risk/reward balance.

EM private credit offers an exciting opportunity for investors to potentially earn compelling returns without needing to extend the leverage and documentation risk in their portfolios.

The high barriers to entry for such a strategy mean that competition on the demand side in this market will likely continue to be outweighed by supply. At the same time, the diversity and depth of the market provides those with relevant expertise and experience an attractive opportunity to potentially achieve compelling risk-adjusted returns.

Click here to learn more about EM illiquid credit.

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