Wednesday, 19 December 2018

​Foundering as the tide recedes

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Emerging market corporate debt issuance ballooned in the good times, but those days are over. Investors are becoming more selective when choosing corporate credits, and default rates are likely to rise – though perhaps slowly – as companies that have borrowed in hard currencies struggle to meet repayments from depreciating local currencies.

Not so long ago, global investors could not get enough of emerging market corporate debt. Companies from Latin America, through Africa and the Middle East, to emerging Asia, would simply amble to market, whereupon they would find a long line of willing and eager investors desperate for a slice of high-yielding paper.

Not to simplify matters too much, but bar a period in late 2013, when investors briefly dumped developing world debt after the US Federal Reserve signalled that the era of US quantitative easing was nearly over, this was an asset class that would have had every reason to feel blessed.

Since the financial crisis, the total outstanding balance of emerging market corporate debt has more than tripled, to over US$2.6trn by end-2014, according to the Institute of International Finance, around 40% of which is printed in US dollars.

“Clearly, emerging market corporate debt issuance has increased at a far faster rate than, say, European or US debt,” said Sergei Strigo, head of emerging market debt and currency at Amundi.

“But a few years ago US dollar-denominated emerging market corporate debt sales were virtually non-existent. So even though the increase is significant, we should remember that a few years ago the asset class was pretty much nowhere. And its development is very positive as it creates broad-based benchmarks for us to work with, while creating liquidity for banks and ordinary investors.”

That may be about to change. Indeed, the ground is already shifting beneath the industry’s feet: 2014 may come to be seen, in hindsight, as a high-water mark for the asset class. Emerging market corporate bond sales have fallen across the board.

In Eastern Europe and Africa, issuance in the current year to August 25 contracted by 53% on an annualised basis to US$31.8bn, according to Thomson Reuters data. In Latin America, volumes shrank by 50% over the same period to US$54.6bn, with issuance also down, by 26.4% to US$22.1bn. Only in Asia did print volumes remain reasonably robust – they shrank versus last year’s figures, but only by 15.3% to US$141bn.

“Asia is the big winner here,” said Cecile Camilli, head of CEEMEA DCM at Societe Generale. “It comprised between a third and a quarter of all emerging-market debt a few years ago. Now it’s half the market.”

The figure is actually even higher: emerging Asia accounted for 57% of all emerging market corporate debt issuance in the year to August 25, against 45% in the same period a year ago and 39% in 2013, according to Thomson Reuters data

Many of the reasons for this slowdown are simple and straightforward. Leading developing economies emerged as the main drivers of global growth in the wake of the financial crisis. Capital was channelled from global investors into the maw of sovereigns and corporates based in cities from Beijing to Brasilia, and Nairobi to New Delhi. Investors were happy to go with the flow, as they searched for high returns in a low-yielding world.

But many, if not most, of those countries are now suffering as capital makes the return journey, readying itself to benefit from rising interest rates in the US. So as one door opens, another closes.


Just as Continental Europe returns tentatively to growth, adding thrust and drive to ongoing recoveries in the US and UK, emerging economies are beginning to splutter. In China, weak industrial data point to a bumpy landing, while Brazil’s economy is set to shrink by at least 2% this year. Emerging market currencies from the South African rand to the Indonesian rupiah have slumped against the greenback.

Neil Shearing, chief emerging market economist at Capital Economics, said a growth model that had supported emerging sovereigns and their prized corporates for the past decade was now “broken”.

Not a cure-all

A slew of more complex challenges also face a callow and nervous asset class. Sachin Dave, a partner at law firm Allen & Overy, warns that too many emerging market firms saw cheap funding as a “panacea” to all their ills.

“They may have spent recent years avoiding instilling better management or creating a workable M&A policy, or perhaps avoiding using their cash reserves more wisely,” he said. “These firms are the ones that are likely to struggle.”

There are, of course, plenty of well-run emerging market corporates with strong management and robust fundamentals, from Indian IT giant Infosys, to Brazilian aerospace conglomerate Embraer, to Mexican oil firm Pemex. Such firms, said A&O’s Dave, “should be well-positioned to weather any market storm”.

Yet default rates are likely to rise, particularly among emerging market firms grown big and fat on cheap credit, and accustomed to being able to tap international debt markets at will.

“Stress rates are rising and one would expect default rates to likely rise too,” said Nicholas Hardingham, a portfolio manager in Franklin Templeton’s Emerging Markets Debt Opportunities team.

Amundi’s Strigo said default rates “are forecast to slightly increase this year versus last year. We’ll have to keep an eye on any corporates running into trouble. This will be done on a case-by-case basis.”

Again, some countries and some corporates will hurt more than others. “It’s the larger, export-oriented firms that are usually granted access to the markets first,” said Hardingham. “Even if you’re exposed to slowing oil and commodity prices, so long as you’re earning in dollars you are going to be favoured by global investors.”

The corollary are firms that earn solely in local currencies, and which have an overwhelmingly domestic business focus – retailers and utilities spring to mind – yet which have sizeable debts denominated in hard currencies like the euro and US dollar.

These corporates, which may also reside in countries that run the risk of large future currency devaluations, are the “weakest link in the chain”, said Hardingham. “One wonders how some of them will repay their debts. This potential weakness is a primary focus of our credit research process.”

SG’s Camilli said the big losers would be the likes of Turkey, South Africa, and a large slice of Latin America. These were, she said, countries that “will be more likely vulnerable as they are reliant on capital inflows, are weighed down by current account deficits, and whose corporates have borrowed actively in US dollars”.

So what can we expect going forward? For one thing, emerging market corporates are likely to have to get used to printing new paper within narrower timeframes, rather than simply issuing debt whenever they feel the urge.

A&O’s Dave said microcycles would predominate, during which the “issuance window opens and everyone rushes to issue debt, then it shuts, and the cycle starts again. The overall pace of issuance will likely be slower too: it will be more like 2012 or 2013, than 2014 and early 2015.”

It will also, A&O’s Dave said, be harder for run-of-the-mill emerging market firms, notably those that only rarely tap international debt markets, to make an immediate or lasting impression on global funds.

Debt investors “will be looking in detail at a country’s political situation, sanctions, overall debt, the impact of lower oil prices – before looking beyond those facts at how a corporate is situated within that framework”, he said.

And there will, said SG’s Camilli, be “more pressure on investors to do their homework, and to look in depth at individual credits. Is a company earning offshore in dollars? Are they less affected than their peers by local vulnerabilities?”

One emerging market-focused fund manager said he hoped the result would be a marked improvement in documentation and issuer quality.

“Too much emerging market corporate debt has been treated in recent years like it’s Triple A rated paper issued by a Fortune 500 company based in New York or Frankfurt. And all too often, it isn’t,” he said.

“I’ve seen plenty of emerging issuers simply print senior unsecured bonds to investors who lap up their pledges of zero defaults. But if you’re a BB– rated corporate from a developing market, that fact should be reflected in the yield you’re offering. We’re going to start to see that happening.”

The winners for the next few years, as interest rates inch up slowly in the US and elsewhere, will probably be solid corporates based in developed-world markets.

“As global interest rates rise, it is to be expected that investors … will become more comfortable about putting their money to work in developed market corporates offering reasonably low yields,” said Franklin Templeton’s Hardingham.

But others should benefit too, notably well-run corporates based in economically robust emerging markets that have spent the past few years becoming better, rather than simply richer. This will be a rising tide that lifts all well-maintained boats, while leaving a motley few to sink below the waves.


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