EM equity ETFs at value discount to bonds, finds WisdomTree Europe

May 5th, 2016 | By | Category: Equities

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Dividend-paying emerging market stocks may present a value opportunity for investors especially when compared to liquid emerging market bonds, according to research from exchange-traded fund provider WisdomTree Europe.

Emerging market equity ETFs at value discount to bonds, says WisdomTree

Viktor Nossek, Head of Research at WisdomTree (Europe).

Viktor Nossek, Director of Research at WisdomTree Europe finds that the fundamentals behind emerging market equities appear to be improving, while revisions to expected US interest rate policies have been supportive of emerging market currencies. The combination of stabilising commodity prices, revivals in energy and mining stocks, signs of tapering in China’s economic slowdown, and evidence of corporate balance sheet restructuring has also served to boost sentiment behind local equities.

Dividend yields are currently at a premium to corporate bond yields, notes Nossek, indicating that investors may have been too bearish when selling off equities during 2015. At the same time, default risk may not be fully priced in as WisdomTree shows thus far this year credit downgrades are high and gathering momentum while average yields remain virtually unaffected.

As chart 1 shows there were 292 downgrades and only 81 upgrades in Q1 2016, while thus far in Q2 the ratio of downgrades to upgrades has already reached the extremes last seen in Q1 2009, with 77 downgrades versus just 13 upgrades. Set against gradual tightening monetary conditions in the US, emerging market debt financed with US dollars may be vulnerable.

Chart 1
Despite these headwinds, emerging market corporates continue to benefit from the benign impact on borrowing costs, strengthening the case for an equity-based investment.  

WisdomTree highlights several Russian energy and mining stocks, one of the worst hit segments in emerging markets amidst crashing commodity prices in the start of the year, as how investors may these dividend paying equities are offering a premium compared to the yield-to-maturity (YTM) on their senior unsecured investment grade rated Eurobonds. These include Gazprom (4.1% expected dividend yield compared to 2.8% bond YTM), Lukoil (6.1% expected dividend yield compared to 5.2% bond YTM), MMC Norilsk Nickel (8.1% expected dividend yield compared to 5.3% bond YTM), and Mobile TeleSystems (8.0% expected dividend yield compared to 5.3% bond YTM).

According to data from Bloomberg dated 15 April 2016, the WisdomTree Emerging Market Equity Income ETF (DEM) and the WisdomTree’s Emerging Markets Small-Cap Dividend ETF (DGSE) both offer exposure to companies with superior leverage and dividend yield ratios compared to a broad sample of emerging market corporate issuers of liquid, investment-grade US dollar-denominated bonds.

Chart 2
Chart 2 shows that on average, stocks in the WisdomTree Emerging Market Equity Income strategy have, relative to the emerging markets corporate bond universe, lower levels of net debt to EBITDA and offer a higher yield. Also, important to highlight is the lower leverage in the commodity-based sectors such as materials and energy, which at 1.8x and 1.9x net debt to EBITDA, respectively, is significantly lower than 5.5x and 5.7x Net Debt to EBITDA in liquid emerging market corporates.

According to Nossek, the yield premium of the non-financial sectors also suggests the extent to which many of the established large-cap emerging market stocks have been beaten down after commodity prices bottomed out in March this year.

Chart 3 shows a similar tale of higher yields and lower leverage for small-cap dividend payers in emerging markets, held within WisdomTree’s Emerging Markets Small-Cap Dividend strategy.

Along with consumer discretionary, IT and industrials, the WisdomTree Emerging Markets Small-Cap Dividend ETF comprises almost 50% of cyclical sectors. Nossek says this makes it not just an interesting yield proposition when assessed with the lower leverage against liquid emerging markets corporate bonds, but also as a secular play on Chinese infrastructure development, and the fast growing consumer services and technology sectors.

Investors may also be interested in the WisdomTree Emerging Markets Asia Equity Income UCITS ETF (DEMA) for a more specific exposure to dividend paying equities listed in the Asian region.

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