Issuance of U.S. dollar-denominated bonds by corporations headquartered in the emerging world began to rapidly increase six years ago. Emerging market governments began to balance their budgets, let their currencies float more freely, significantly reduced their external debt, and became large global net creditors (Exhibit 1).¹ As the supply of external sovereign debt declined significantly, these economies experienced a significant increase in GDP growth as a result (Exhibit 2). Moreover, as many governments began to aggressively retire their external sovereign debt by redirecting financing towards budding local currency markets (please see our paper entitled "Emerging Market Debt: It's Not Just the EMBI Anymore!"), the crowding-out of corporations by their respective governments in the external markets was significantly reduced. The void created by the absence of sovereign issuance was quickly filled by corporations with significant capacity constraints but limited local financing opportunities.

Fast forward to today and we see that corporate issuance comprises over 60% of the U.S. dollar-denominated bond market (Exhibit 3).² It is our belief that investors who remain focused solely on sovereign issues have restricted themselves to an increasingly outdated and overbought corner of the emerging market fixed-income universe. This paper outlines the growth of the corporate bond market in the emerging world, and presents what we believe to be a stand-alone asset class with significant first-mover advantage.

Industrialisation, Urbanisation and the Corporate Bond Market
GDP growth in the emerging world has outpaced growth in the advanced world every year since 1990 and has grown three times as fast since 2000. The gap in living standards, while still wide, is narrowing. Emerging market GDP now comprises 30% of the world's total, up from 20% a decade ago and now larger than the 25% U.S. share³. Global purchasing power is shifting away from the United States and European consumers at the margin, towards emerging market governments, corporations and consumers. More significantly, 85% of the world's population calls the emerging world home (Exhibit 4). And that population is anything but static: it is young, growing rapidly, and displaying a mobility never before witnessed. Spending on consumer goods has so far been restrained, but there are clear signs that emerging market consumers are exerting themselves in a transformative way. Tens of millions of people relocate from the country to the city every year in what demographers refer to as a rural exodus4. The rapid rise in urbanisation has put tremendous strain on resources and outdated infrastructure, and now presents serious policy challenges for governments. Nevertheless, this rapid urbanisation has also created lucrative opportunities for businesses and private investors.

The growth strategy recently pursued in emerging market countries is similar to that pursued by Western Europe during the two-decade post-World War II reconstruction phase. In fact, the characterisation of advanced economies as "industrialised" is a relic of that post-war era. Western European economies are now dominated by the service sector, whereas low- and middle-income economies are the true "industrialised/industrialising" nations.

The aforementioned growth strategy hinges on empowering the corporate sector as the engine of export-oriented growth⁵. It begins with a government policy that suppresses real wages below equilibrium. Demand by corporations for artificially cheap labour then expands, absorbing more and more labour from the fields into the cities. Since productivity tends to be much lower in agriculture, the productivity of the overall economy rises as workers are drawn into the more productive industrial sector. As a result of this shift in resources, prices on manufactured goods like apparel and furniture have been trending significantly lower while food prices continue to soar. Corporations, in exchange for the benefit of artificially cheap labour and inflated profits, agree to engage in a high level of internal investment, and, in turn, hire more workers to operate an ever expanding capital stock.

This export-led development strategy focuses on the supply-side of the economy and encourages rapid industrialisation. Therefore, it is no wonder that the most prominent corporations headquartered in the emerging world are involved in energy production, basic industry, and metals and mining. These sectors benefit disproportionately from absorbing unskilled labour from the countryside, can efficiently expand their capital base, and export a large share of their output to advanced economies. These are exactly the sectors that are well-represented in the U.S. dollar-denominated (external) corporate bond market (Exhibit 5). However, after years of rapid global economic growth, retained earnings and internally generated funds are no longer sufficient to fund capital expenditures and expand operational capacity. Therefore, emerging market companies are turning to international bond (and equity) markets as a complimentary source of funding. A company as large and powerful as Brazil's Vale can obtain bank and even limited bond-market financing in local capital markets, but has increasingly turned to external markets where financing terms are quite attractive (see Box 1).

Current Market Characteristics: The Rise of Essential Industry
Corporations in the energy, basic industry, and metals and mining sectors are not the only emerging market companies that are expanding rapidly and issuing external bonds. Industries such as telecommunications, banking, homebuilding and utilities are essential for ongoing economic development, and are beginning to expand rapidly. These sectors are necessary to relieve what would otherwise become bottlenecks in unprotected and increasingly integrated economies. For example, businesses would find it difficult to reap the rewards of economies-of-scale without cost effective telecommunications, a necessity for coordination across product lines and management of vertical and horizontal integration. America Móvil, a Mexican telecommunications company, is a prime example of the sort of company that is fulfilling this need (see Box 2). Likewise, basic infrastructure such as shelter, water and electrical utilities must be built to provide for the millions of new city dwellers. This is necessary in order to allow a gradual rebalancing of emerging market economies away from export-oriented growth and towards greater reliance on domestic consumption.

The financial market crisis that erupted in the advanced economies during the second half of 2007 has demonstrated that a sound financial system is an essential component of economic stability. And, as we have recently witnessed (Northern Rock and Bear Stearns are two examples), because of positive externalities, the banking sector often enjoys implicit government support. With respect to emerging economies, banking services are not only convenient for a blossoming middle class, but a weak banking system can undermine the effectiveness of central banks and their ability to implement monetary policy. Banks must allocate capital efficiently and transmit central bank action without delay. For example, when central bankers are forced into an inferior position of pegging their nominal exchange rate or directly regulating bank lending and deposit-taking (the traditional "use" of banks by emerging market governments), they are left without the proper market-based monetary tools to guide the economy through turbulence. As this is precisely the situation that many emerging countries have faced over the last few decades, and as international capital flows have become much more powerful over the same time period, expanding the breadth and depth of financial services has become a priority for most governments.

The importance of the banking industry has, in turn, fuelled a boom in the issuance of debt by banks even as the industry has continued to consolidate (note Mexico, Korea and Kazakhstan). The general consensus continues to be that a more concentrated industry composed of a few large banks is healthier than a large number of small banks⁶. Contrary to the threat to competition, large banks with greater market share have a more diversified asset base and can better manage risk and negative shocks. Second, large banks can raise capital more easily than small banks in international capital markets, the proceeds of which are often used to enhance stability, update risk systems and even expand offshore operations. ICICI Bank of India, for example, has financed its rapid expansion partially with the issuance of external debt (see Box 3).

The New Yardstick to Track Emerging Market Credit: JPMorgan's CEMBI
JPMorgan's Corporate Emerging Markets Bond Index (CEMBI) family, which we expect to become the new benchmarks for emerging market hard currency debt investors, may soon replace JPMorgan's well-weathered sovereign indices, the EMBI family. The CEMBI Broad represents over $200 billion in market capitalisation across 34 countries and 351 bonds. We expect the market capitalisation to reach $350 billion within a few years, if not sooner. This is larger than the $295 billion in market capitalisation on the sovereign EMBI, which we expect to fall to $275 billion over the same period. The banking sector, not surprisingly, has quickly become the largest component of the CEMBI Broad (see previous discussion and Exhibit 5).

The CEMBI Broad restricts inclusion to issues with a face amount greater than $300 million, a maturity greater than five years, and ample trading volume for daily hand-pricing. Emerging market corporate trading volumes are growing impressively and, as shown in Exhibit 3, new issuance continues to hit the market. The Index has an average investment grade rating (BBB-) with 80% of issues rated BBB and 15% rated BB. Still, despite having a higher credit rating, the spread on the CEMBI, at 350 bps, is nearly 70 bps above the sovereign EMBI benchmark. We attribute this partially to a liquidity premium, but primarily to a lack of coverage and familiarity with the asset class by the broader market. Needless to say, we feel emerging market corporate debt is an undervalued asset class. As trading volumes grow and liquidity improves, and as more credit analysts expand their coverage of these companies, the asset class should continue to offer compelling potential for capital appreciation on top of already high relative yields (Exhibit 6). A look at the risk-adjusted returns of the past three years relative to the U.S. high-yield market bears this out (Exhibit 7).

It is worth readdressing the fact that the CEMBI Broad is considered to be higher-quality than its sovereign counterpart. It was once thought that corporate debt suffered from a "sovereign ceiling," or an upper bound on ratings determined by its sovereign host. This had been justified by the existence of "transfer risk," or the possibility that governments facing repayment difficulties would raise taxes or seize private sector assets, and impede the private sector's ability to service its own debt. As Cavallo and Valenzuela (2007) state, "We find that while sovereign risk increases corporate risk, there is no support for a strict sovereign ceiling hypothesis. The point estimate that measures the elasticity of sovereign risk to corporate spreads is 0.38, which is significantly different from 1."⁷ This measure was thought to be 1.0 until S&P adapted to changing conditions and relaxed its strict sovereign ceiling policy in 1997. Moody's followed suit in 2001. As firms generate their own foreign exchange through international trade, and as government policy has become more responsible, transfer risk has plummeted. Many of these multinational corporations headquartered in the emerging world have decoupled from their sovereign hosts.

The implication, of course, is that for the emerging market corporate bond investor, the analysis of systemic risk is declining in importance while the analysis of idiosyncratic risk is increasing in importance. The investment process is shifting towards the bottom-up rather than the top-down. The assessment of variables such as managerial competence, reliability of supply-chains, volatility of cash flow and other firm-specific variables increasingly overshadows variables such as GDP growth, political accountability and other macroeconomic factors⁸.

Western Asset's Investment Approach
As fixed-income investors, we focus not on "earnings" upside, but on the downside; not on profitability per se, but on a company's ability to generate sufficient operating cash flow to consistently make coupon and principal payments. In this regard, we believe it wise to focus on industries that are essential to ongoing industrialisation and urbanisation in the emerging world. These are the corporations that issue bonds to expand capacity and unclog bottlenecks in the ongoing growth process that is transforming the world as we know it: banking, oil and gas companies, infrastructure developers, utilities, telecommunications, etc.

Like Cavallo and Valenzuela (2007), we believe emerging market corporate bond prices are largely determined by firm-specific factors. While the investment process begins with an assessment of the global economy and country-specific risks, the bottom-up issue-selection process receives more than equal attention. We have a large team of credit analysts in every industry, located in local markets around the globe. Analysis is coordinated by the portfolio management team in Pasadena, with a focus on identifying undervalued sectors, companies and securities relative to their long-run fundamental value. This has been the backbone of Western Asset's corporate credit investment process since the firm began, and has delivered strong out-performance in dedicated corporate mandates.

With the inclusion of debt issued by corporations located across the globe, credit markets are beginning to truly represent the global production process. Western Asset looks forward to the opportunity to extend our comparative advantage in credit analysis to a much larger universe. While the U.S. still has the world's largest corporate bond market, this may not last much longer; both outstanding market capitalisation and trading volumes are growing exponentially faster in the emerging world.

Footnotes

1. Debt issued by emerging markets denominated in currencies other than their own are referred to as External debt. External debt is nearly always denominated in so-called "hard currencies", or those of the major advanced economies, usually the U.S. dollar or to a lesser extent, the euro and the yen.
2. According to the Bank for International Settlements, issuance totalled $700 billion up till the 3rd quarter of 2007. This compares to $430 billion of outstanding sovereign issuance. These calculations include all issues including those that are illiquid and not part of what Western Asset considers the "investible universe". Developing countries are classified per World Bank guidelines.
3. Source: IMF, based on market exchange rates.
4. Kamrava, Mehran, "Politics and Society in the Developing World", 2000; Routledge.
5. Barry Eichengreen refers to the strategy as "neo-corporatist", where collaboration between the government, corporations, and labour unions allowed a balanced growth path leading to convergence with the U.S. that was sustainable for over two decades. Please see "The European Economy since 1945: Coordinated Capitalism and Beyond".
6. Turner, P., "The banking system in emerging economies: how much progress has been made?", BIS paper No 28, 2006
7. Cavallo, E. and Valenzuela, P., "The Determinants of Corporate Risk in Emerging Markets: An Option-Adjusted Spread Analysis", IMF Working Paper, September 2007.
8. Cavallo and Valenzuela (2007) find that firm-specific factors account for approximately 33% of the total variance in corporate risk. In contrast, macro-economic factors explained a relatively small 4% of the total variance in corporate risk. Global and sovereign risk factors account for 9% each.