From an investment perspective, Latin America remains perhaps the most attractive region within Emerging Markets, and in particular for corporate bonds. It offers higher yield and diversification to developed market investors looking to play the regional story. In addition, there is strong regional demand from one of the most dynamically growing pension fund industries, which is keen to invest in its home market.
We believe that the investment case for Latin America remains valid, in particular for developed market investors looking to combine higher yield and diversification with the specific regional story. As the chart below shows, Latin American corporate bonds continue to offer a significant yield pick up. Duration, on the other hand, is materially shorter, standing at 5.4 years at the end of July compared to 6.9 years for Euro corporates and 7.4 for US corporates.
The region not only offers attractive yield and duration but also ample depth and breadth to build stand-alone portfolios. The total external bond stock, which is composed of corporate, quasi-sovereign and sovereign bonds, amounts to USD 847 billion as of June 2017, or 30% of the total emerging markets external bond stock of USD 2.83 trillion. Latin America also offers more potential for rerating, as the split between investment grade and high yield is 48%/52% (in comparison, the split in Asia is 75%/25%).
Another point supporting the investment case is the broadly diversified industry sector distribution. To start, Latin America is less skewed toward financials than the overall emerging corporate bond market. Financial services account for only 26% compared to 31% for the overall market. In addition, TMT, consumer, pulp & paper and transport sectors have bigger weights; oil & gas, utilities, metals & mining and industrial are more or less the same; and real estate and infrastructure have smaller weights.
The outlook for Latin American corporate bonds is further supported by strong demand from local pension funds. The IMF estimates the size of the pension market to have reached, in aggregate, USD 700 billion in the top seven countries (Brazil, Chile, Colombia, Mexico, Panama, Peru, Uruguay) and more recent studies suggest it could have risen to USD 900 billion. Brazil is the biggest market in absolute terms, followed by Chile and Mexico, but relative to GDP Chile is by far the biggest (see chart below).
In addition, regional pension funds invest primarily in bonds (see chart below). The bulk is still invested in government debt, but as the funds are growing they are increasingly investing in corporate bonds, including in other countries in the region, while regulatory caps on risk tolerance mean that pension funds will continue to invest primarily in bonds.
The outlook is generally perceived to be positive, especially for countries with mandatory private pension systems, such as in Chile, Mexico, Peru and Colombia. Countries with traditional pay-as-you-go systems, such as Brazil, are facing the challenge of fiscal constraints. Nevertheless, growth rates are expected to remain relatively high partly due to favourable population pyramids. Moreover, as local regulators are gradually easing cross-border investment guidelines, pension funds are expected to increase their exposure to regional fixed income strategies.
Is it a good moment to invest in Latin American corporate bonds?
A look at Latin America vs EM corporate bond spreads suggests that there is limited room for spread compression. At the end of July, the Latin America spread traded about 40 basis points wider than the EM composite index spread, whereas they have been trading, for the most part, more or less in line since 2009. However, this spread pick up is mainly due to a widening of Brazil spreads, and given political and economic uncertainties, it may not significantly compress in the near future. In addition, the composite spread is only about 30 basis points wider than its post-Lehman low, which suggests that spreads have generally not much room to move lower.
This does not mean, however, that there is no value in Latin American corporate bonds. As mentioned above, carry is relatively attractive, in particular compared to developed market bonds. In addition, it has been possible to earn high single or even double digit returns in the past even at low spread levels. The chart below shows two-year historical total returns for given levels of spread. Most of the time, total return has been positive, even at lower levels than the current spread of 328 basis points; the average return was around 14%. This indicates that even low current spreads could offer an attractive point of entry for investors looking for a strategic exposure to the region.
In sum, Latin American corporate bonds offer attractive yields, duration and diversification relative to a developed market portfolio. The market has enough depth and breadth to construct portfolios which are broadly diversified across countries, sectors and issuers. The growing pension funds industry is a major investor, which further supports the outlook. Finally, spreads are relatively low in historical comparison, but previously returns have been mostly positive even at such spread levels, offering long-term investors an attractive entry point.