Tints and hues

The result is certainly diverting but not entirely confidence inducing. Take the struggles of Europe’s financial minds to build credible and workable regulation to enable the stress tests that were seen as crucial to stabilising the eurozone banking sector. If this was a lesson in policymaking, it fell well short of textbook, moving from the hapless Committee of European Banking Supervisors through the European Banking Authority to the European Central Bank. Central banks and regulators have also struggled to talk the same language in the debate about how to help non-financials, with the ECB keen to support SME funding via securitisation and repeatedly calling for changes to rules on ABS. On rates the strategies of the ECB and Fed could not be more different, for the first time since 1997–98. Europe looks set to enable the games to continue with further loosening through 2015, just as the Fed picks up its ball and heads home for tea. It stretches the school analogy to breaking point to suggest the events in Russia, Ukraine and the Middle East are mere fisticuffs in the playground, yet behaviour in the emerging and frontier markets is broadly on the up. Latin America’s capital markets are back in the good books, Sub-Saharan African sovereigns are outperforming while the new man, India’s prime minister Narendra Modi, is definitely the teacher’s pet – for now. EMs are also becoming more attractive to each other, thanks to global reach of a credit ratings industry that has not only weathered the fallout from the financial crisis, in which it played a lead role, but has arguably grown in relevance as a result. Yet the European chaos may yet produce the correct result. While the formula for stress testing was initially ridiculed for being as strict as a substitute teacher, the process has ultimately yielded a more nuanced approach to bank crises, risk and thorny questions such as the bailout. The contrast with the US’s decisive Federal Deposit Insurance Corporation may be striking, but the European approach is premised on a fairly realistic assessment of behaviour in a climate in which liquidity, anyway, is in short supply. Banks are inherently unpredictable – and you can’t push them too quickly. It is this nuanced and – dare one say – relaxed approach to punishing capital (what might in fact be called “capital punishment”) that helps to put into context the eurozone periphery’s surprising good humour when it comes to sovereign debt. A year ago Ireland, Portugal, Greece and Spain were looking decidedly queasy – today they seem to be full of beans as they prepare to feast on the market. So far even bad news on growth has failed to spoil appetites as it brings closer the real prospect of quantitative easing. Children, it seems, will be children – with few limits to their imagination when it comes to ensuring that the adults don’t ruin their fun. Take Europe’s playful enthusiasm for CoCos – bespoke – and, to some, over-complex – they may be, but never underestimate the propensity of youngsters to embark suddenly in radically different directions at exactly the same time. They are, in short, a force of nature. To see the digital version of this report, please click here. To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

The past year has seen frontier markets come of age as investors plough money into markets from Argentina to Nigeria to Vietnam, desperate for returns in the low to mid-teens. No single band of people better personify the contrarian human desire to overpower, tame and label than the explorer. From Magellan to Cook to Amundsen, history is littered with the brave and foolhardy, enduring the worst of the planet’s elements, then rushing home, like eager schoolboys, to give the rivers, mountains and gulfs of their conquered lands a name. So it is with the investing world. The more adventurous funds love risk – or, more precisely, love the yield that accompanies it. And in our oppressively low-yield world, risk often only exists in genuine quantities in securities and markets far from the home of the archetypal investor, in the wilder and woollier reaches of Africa, the Middle East, Asia, and emerging Europe. In time, investors have found ways to corral their tagging-and-labelling fixation. First, they created the emerging market asset class, covering everyone from South Koreans to Russians to Brazilians. Dissatisfied with their work, they spawned a second asset class, spanning the world’s wilder and woollier frontier-market states, typically those offering higher growth and yields. The past year has seen many of those frontier markets come of age. Investors are ploughing money into markets from Argentina to Nigeria to Vietnam like never before, desperate for returns in the low to mid-teens. In the first eight months of 2014, global investors pumped US$2.2bn into frontier markets, according to data provider EPFR. Even the most obdurately conservative investors have become believers. In June, Norway’s US$886bn sovereign wealth fund added frontier markets to its portfolio. Oddly, the waxing of frontier markets has coincided with a waning global appetite for emerging market securities. Marcus Svedberg, chief economist at East Capital, points to a “curious” recent phenomenon wherein emerging markets have, since mid-2013, “underperformed, while frontier markets did quite well”. Capital usually trickles through emerging markets and on into frontier markets, but in recent quarters, the former have been bypassed almost entirely, a situation Svedberg said was “actually rather strange”. Data bear this out. Foreign funds withdrew US$720m from emerging markets in the first eight months of the year, according to EPFR. And while the MSCI Frontier Markets Index gained 17% in the year to August 22, the MSCI Emerging Markets index rose by 10%, and MSCI World benchmark by just 5%. In part, that divergence can be explained by last year’s “taper tantrum”. When former Federal Reserve chairman Ben Bernanke in May 2013 announced his intention slowly to reduce the Fed’s pace of bond-buying in response to firming market conditions, he sparked a mass sell-off in emerging market securities. That led to the creation of another investor-labelled box filled with the so-called “fragile five”, a diverse group of nations from Brazil to Indonesia. All had large current account deficits and were deemed to be overly dependent on external financing. Global funds fled the likes of India and Turkey, economies accustomed to a certain level of global investor adulation, yet now viewed as inherently risky, offering slowing growth, political uncertainty, and currency volatility. Keen to reallocate capital to markets offering higher yields and returns, many funds opted to plough a new furrow in frontier markets. To their surprise, they discovered that the asset class offered not added danger but a “relatively benign risk-aversion environment”, said Benoit Anne, head of emerging markets strategy at Societe Generale. This was in large part due to the protection afforded by the markets’ relative isolation. Small is beautiful Small in this scenario is beautiful. Nigeria’s stock exchange may be large in African terms, and Nigerian securities may account for one-fifth of the MSCI F

The hope in the region is that this bond market growth is representative of a more sophisticated mindset among issuers and investors. But there are fears that normalised Federal Reserve policy could end this golden era. “The end of quantitative easing in the US should have put pressure on Asian interest rates and foreign exchange. This view has been challenged by talk of European QE and resulting outflows from the euro into US dollars as well as Asian currencies,” said Herman van den Wall Bake, head of Asia-Pacific debt capital markets at Deutsche Bank in Singapore. “On balance, we think the carry trade will therefore last longer than initially anticipated and Asian rates, credit and foreign exchange markets will continue to benefit from the artificial liquidity being provided collectively by the Fed, ECB and Bank of Japan.” Dangerous experiment QE has more than its share of detractors and there is a school of thought that regards it as a dangerous experiment that contains inherent excesses and one that cannot be withdrawn from without consequent market mayhem. Certainly, in May 2013, when QE easing was first mooted, Asian capital markets took fright and the issuance window slammed shut for around two months. Nevertheless, it opened again in convincing fashion and Asia’s solid economic backdrop together with the ongoing quest for yield allowed a record US$142bn equivalent to print from Asia’s offshore primary debt capital markets last year. Barring nasty accidents, that figure should be surpassed this year. Some US$124bn has printed in the offshore Asian debt markets in 2014 to-date, according to data from Thomson Reuters, and the pipeline is as packed as it has ever been. Indeed, the buzz phrase for Asia since its remarkable recovery from the financial crisis has been the ”new paradigm” of financing conditions that are on offer to Asia’s institutions and companies. ‘Goldilocks’ conditions With Asian bond markets offering a classic example of disintermediation away from the loan markets – a certain relief given that European banks have been trimming balance sheets and are not the force in the region’s loan markets they once were – it is easy to understand talk of a new paradigm or “Goldilocks” conditions, where ample liquidity seems to chase just about any issue on the radar, at whatever point on the credit curve. There have been some idiosyncratic events in the region that have had a positive impact on Asia’s credit backdrop, principally decisive election victories in India and Indonesia, which regional bankers suggest are already filtering through in terms of these countries as a credit proposition. The end to political impasse in Thailand has created a sense of relief and the country is still courted assiduously by bankers in the region. “Yes, we are already seeing a noticeable change in mindset in both India and Indonesia. Now that the electoral uncertainty is behind us, both the private and the public sectors can decide on their capex plans and how to finance them,” said Deutsche’s van den Wall Bake. “We have seen a nascent HY market in India being warmly welcomed by investors seeking diversification and Indonesian credits have a deep investor base to tap into. Loan markets are equally eager to gain exposure, so issuers will not lack financing options.” According to minutes from the June FOMC meeting, QE should end by October and so the market will have a chance to confront “taper terror” much sooner than was expected at the start of 2014, with early 2015 seen as a likely point for the brakes to be put on QE. The question is whether there will be capital flight from Asia, as has been the case during previous Fed increases. “Balance sheets in the region may not be flush with as much cash as they were, say even three years ago, and household debt as a percentage of GDP has been rising. And we have seen from the sharp fall in the Indian rupee and Indonesian rupiah last year that current account deficits can spook markets,” s

While expectations of India’s new prime minister Narendra Modi were initially as sky-high as the rocket to Mars launched last year by the country’s space agency, reality is bringing them back down to earth. Stratospheric hopes of a radical economic transformation under the new leader, who took office in May with the strongest parliamentary majority in 30 years, are now being reined in. Early signs suggest that Modi is already sticking to what he is good at – delivery – and appears to be taking a long-term view of reform in Asia’s third-largest economy. The head of the Hindu-nationalist BJP secured power with an image as a decisive leader determined to end years of policy drift and confront slowing growth and high inflation. He inherited a rudderless economy from the previous Congress party government with growth – at 8.5% four years ago – lagging at 4.4% in 2013. Inflation, fuelled by a fiscal deficit bloated by costly subsidies, has hovered at 10%. But hopes that the landslide by Modi’s National Democratic Alliance coalition would end the multi-party gridlock that has hampered growth prompted economists to raise forecasts. A consensus projects 5.4% growth this year, rising to 6%–6.5% by 2016. Rohini Malkani, chief economist for Citi India, said: “The Indian economy may be turning a corner, as reflected in recent macro data trends. Industrial growth has picked up, exports have been rising at double digits and CPI inflation has slowed to a 30-month low.” Modi’s victory had an immediate effect on the capital markets, fuelling expectations of an investment-led turnaround. Casey McLean, portfolio manager and analyst at AMP Capital in Hong Kong, warns that a lot of the inflows in anticipation of a Modi victory were fast money fuelled by hype. McLean said: “Since the reporting season kicked off in India that fast money is now looking to become more defensive, and I think that will be ongoing for a while – but if Modi is going to be a success it’s not going to be in a few months, it’s going to be in a few years, and this sort of correction is the opportunity to get in for the longer term.” Jan Dehn, head of research at Ashmore, believes that higher valuations were already priced into the Indian equity market in anticipation of the election. Dehn said: “A lot of people sat on their backsides for way too long and then when they saw the election outcome they piled in – but by then the smart money had already invested and the rally had to a large extent already happened, and that money is just going to sit there and think ‘When are the fireworks going to happen?’ and is going to get impatient.” The hype is giving way to questions about how Modi will confront persistent weaknesses: a common view already emerging among analysts is that he has not articulated a particularly distinct – or emphatically clear – economic vision. Mark Williams, chief Asia economist at Capital Economics, said: “The problem is that people are so disillusioned with the past government that the new administration has been able to come in and be cast in a very positive light simply by saying that they are going to do things differently; but they haven’t really specified what.” Jahangir Aziz, chief economist for India at JP Morgan, says the government has not articulated clearly its understanding of what it sees as the binding constraints to growth.   “If Modi is going to be a success it’s not going to be in a few months, it’s going to be in a few years, and this sort of correction is the opportunity to get in for the longer term”     “The collapse that has happened over the last three or four years in growth, the virulent inflation, the depreciation of the currency – this is the closest India has come to a crisis-like situation since the debt crisis of the early 1990s. So if there was a moment when you could step up and say ‘India needs a different direction of reforms, a different world view of how it is organised, and a fundamental view of how economics needs to be

Bond issuance is on track to top US$120bn, up from US$105bn last year, as investors crank up demand for high-yielding LatAm paper. Quantitative easing drawing to a close and rising US rates has fuelled a surge of refinancing activity and as of August, the market had garnered US$92bn, up from US$64bn in the same period last year, according to Thomson Reuters’ data. Sovereign issuance is up 85%. “It’s been a busy market and more active than many people anticipated,” said Katia Bouazza, HSBC’s co-head of global capital markets for the Americas. “Overall, we are seeing better stability and a better outlook for most issuers within their activities and countries. It’s not just the future rates, the backdrop for emerging markets is more stable and encouraging.” That message has, of course, not been lost on corporates and sovereigns eager to profit from “a historic window to issue huge amounts of long-term debt”, said Mike Fitzgerald, chair of the Latin American practice at law firm Paul Hastings. “They are seeing this as a real chance to do deals before the low-rate window closes.” “There is a lot of pre-financing activity as Treasury spreads are double what they were before the [taper] tantrum concerns,” said John Jairo Ramirez, a fixed-income analyst at Banco BTG Pactual’s Colombian franchise. “Companies are rushing to obtain funds amid signals that conditions could worsen.” “There have been more 30-year bond issues this year than there have ever been in LatAm,” said Fitzgerald. “Some issuers are retiring debt issued during the financial crisis at 10% with debt issued today at 7.5%.” Chris Gilfond, regional co-head at Citigroup, said at the current rate transactions in the region could top 200 this year. Even if issuance slows from now on, it will be a record year in LatAm with well over 200 transactions after racking up 127 so far, he said. Mexico has seen a surge of activity, with deal-making up 80%, double the region’s 45% increase. Brazil, damaged after oil giant OGX’s bitter bankruptcy last year, has recovered to stage a 36% gain while Peru, Chile and Central America issuance is up 30%. Showing just how much investors are willing to gamble for yield, in June Ecuador raised US$2bn in a bond issue that met vigorous demand. Just five years earlier, President Rafael Correa had branded creditors “true monsters” when defaulting on US$3.2bn of notes. The sovereign priced the 10-year paper to yield 7.95%, attracting as much as US$5.1bn in orders. Overhyped? Despite the enthusiasm, investors say the buzz surrounding the market has to be taken with a pinch of salt. Shamaila Kahn, EM corporate bonds manager at AllianceBernstein, said 2014’s gains were largely driven by liability management rather than funding growth. Yet the equity market would love even a hint of fiesta. Issuance looks like it could fall short of last year’s US$30bn. However, market sentiment has improved, driving deals in Mexico and most recently in Brazil, where growing prospects of a win by opposition presidential candidate Marina Silva in October’s elections is boosting hopes that the country can lift its economy from recession. “Compared with 2012 and 2013, the market dropped a lot in 2014,” said a Mexico City-based equity analyst, noting that investors have fretted about Mexico’s sluggish economic growth. “There has been a prolonged weakness, which has cut appetite for Mexican assets,” the analyst said. However, energy reforms are now signed into law, bringing expansion opportunities for private companies eager to grow in Mexico’s oil and electricity sectors. The analyst expects the legislation will be a key ECM driver next year and in 2016. Mariano Gaut, Citigroup’s regional capital markets co-head, is optimistic that M&A activity could drive equity offerings, including carve-outs, in the next 12 months. IPOs are likely to remain in the established consumer, real estate, property and diversified industrials sectors, but Gaut is enthused about the prospects fo

Banks bore the brunt of public ire, but the fallout from the events of late 2008 was ultimately just as grisly for credit rating agencies. Industry colossi Standard & Poor’s, Moody’s Investors Service and Fitch Ratings were, if not hobbled, then at least humbled. Why, investors, governments and regulators wanted to know, had CRAs not foreseen the destruction of so much hard economic work – and the onset of a recession from which many nations have yet to emerge – by a tiny slice of the financial sector? Since those dark days, much has changed in an industry perpetually under pressure to adapt to the permanent revolution under way across global capital markets. Olivier Beroud, regional head, EMEA, at Moody’s, sums up the situation by highlighting “two major types of change” buffeting the industry. “First, the emergence of new markets, and finance moving to new places,” he said. “Second, the ongoing challenge of seeking to retain both a global and a regional view while at the same time bringing transparency to a company or situation.” The first challenge is merely the latest extension of our desire to allow money to wash from developed to developing or frontier markets, and once there, to set down strong roots. Capital then forms far from its traditional homesteads (the US and more latterly Europe) before being reinvested wherever returns are highest. Thus, said Moody’s Beroud, “investors in Asia look at credit risk before taking a position on Turkey; Turkish investors are looking at credit risk on Russia, and so on. It’s a complex, interconnected and increasingly global process.” It is one of those wonderful ironies that fate delivers to our doorsteps and offices, that makes securing a credit rating on your stock or bond “more important now than ever before”, said Beroud. Nor is that mere sales patter: a complex world awash with data reinforces the importance of being able to access a single source (or several trustworthy sources) able to make sense of it all. Yet whom to choose when picking one or more agencies? Do you plump for a big-three player like S&P, or one of the smaller, national or regional players springing up around the world? Should investors, when costs permit, be augmenting CRA data and opinions with their own internal research? No one-size-fits-all The reality is that no one-size-fits-all approach exists. The post-crisis survival of the big-three CRAs has been perhaps less of a surprise than their ability to adapt and change to a new and more challenging regulatory world. Pre-crisis, the industry, said Sam Theodore, managing director, financial institutions at Scope Ratings, was “fairly unregulated”, a situation that led ultimately to “so many ratings on financial institutions in particular prov[ing] to be so spectacularly wrong”. Yet CRAs are now as tightly regulated as any commercial lender. New rules have been slow to come, but they are now there in force. The Paris-based European Securities and Markets Authority has long been a withering critic of an industry whose biggest players handed Lehman Brothers a Single A rating a month before its collapse, and wrongly predicted Greece’s exit from the single European currency. In August 2014, the US Securities and Exchange Commission pushed through rules to tighten controls on the industry, handing investors “powerful new tools for independently evaluating the quality” of ratings agencies, noted SEC chairwoman Mary Jo White. The new rules, said Scope Ratings’ Theodore, gives investors “hope that they are no longer on their own facing the big agencies”. Others are not so sure. SEC commissioner Daniel Gallagher dissented on the vote, criticising the new rules for failing to ensure ratings are not unduly influenced by the profit motive. The Chinese Walls separating sales and analytics teams at the big three are broader and taller than ever. But a tendency to hove to the views of those that pay you the most, and instinctively to be predisposed to rate an economi

To see the digital version of this report, please click here. To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com. A quick glance at the headlines would lead to the natural conclusion that now is not the best possible time to invest in emerging markets. Escalating tensions in Russia and the Middle East, coupled with political changes in a host of key emerging markets, including Brazil, India and Indonesia, have ramped up the geopolitical risks. Meanwhile, regional blocs of countries that had previously moved in tandem have begun to go their separate ways, making investment decisions more complex. But scratch the surface and many investors are quietly bullish on emerging markets. The tailspin caused by last year’s announcement of the US Federal Reserve’s plans to scale back quantitative easing, which led to a massive sell-off in EM assets, is now a distant memory, and there is a widespread belief that many emerging market assets now have better prospects than developed markets. “We have seen an inflection point in emerging markets this year and fundamentals are now coming back. EM assets will not trade in a single direction going forward – there is substantial alpha to be made on the dispersion between individual countries’ fundamental and idiosyncratic risk. In our team, we are taking a relative value approach to capture the best investment opportunities,” said Sergio Trigo Paz, head of emerging markets fixed income at BlackRock. One of the challenges inherent in emerging markets, which has been particularly prevalent over the past year, is to distinguish clearly between economic fundamentals and price volatility. It was the frenzied reaction to the initial talk of QE tapering in May 2013 that first led to major price movements, but fundamentals remained, for the most part, fairly resilient. Victims of the price volatility have spanned multiple countries and asset classes, but currencies are a case in point. The Indian rupee, for example, weakened sharply in the aftermath of the tapering announcement, losing more than 24% of its value against the US dollar between May and September, while the Indonesian rupiah lost nearly 20% of its value during the same period, according to data from Thomson Reuters. More recently, political tensions in Russia and Turkey led to sharp moves in the rouble and the lira this year. Fundamentals But the violent moves and pessimistic voices that were so widespread in emerging markets during the second half of 2013 turned out, for the most part, to be inconsistent with economic fundamentals. China, for example, which was beset by concerns over a “hard landing” for its economy, saw GDP growth of 7.7% in 2013, according to the World Bank. GDP in India was 5.0%, and in Indonesia it was 5.8%. When compared with much more anaemic growth in developed markets still struggling to emerge from the economic downturn – 0.4% GDP growth in Germany, 1.7% in the UK and 1.9% in the US – it is easy to see why EM have become so attractive for investors. But the negative assumptions driven by price volatility can be a problem for fund managers looking to attract risk-averse investors. “Emerging markets are actually one of the most inefficient asset classes on the planet, because prices often move completely away from the underlying fundamentals. Despite all the doomsday predictions, what happened last year was really just a technical adjustment in prices, but EM fundamentals actually remained remarkably robust,” said Jan Dehn, head of research at Ashmore, a London-based EM investment management firm. The sell-off in EM assets cheapened prices dramatically and meant that when sentiment did begin to improve earlier this year, investors were able to take advantage of very undervalued assets. Amid weaker than expected growth in developed markets and concerns over inflation in the eurozone, the intrinsic value of EM has only become more attractive as the year has progressed. “

In August, Ecobank Nigeria sold US$200m of dated subordinated notes, due 2021 with a yield of 9%, joining two other Nigerian lenders, Access Bank and First Bank of Nigeria, which came to market with bond issues of US$400m and US$450m, respectively. The banks are all looking to raise money for investment in the West African country’s infrastructure and energy industry. The banks’ fundraising comes hot on the heels of a round of international issuance by Sub-Saharan African sovereigns, which have turned to the capital markets to plug short-term holes in their budgets and finance capital investment in infrastructure and social programmes. The increasing international debt load in some countries is, analysts warn, perpetuating the high interest rates that are blocking African corporates’ access to finance. This, along with volatile currencies and a lack of scale, means that aside from a few outliers in the financial or natural resource industries, few companies are likely to benefit from the buoyant market for high-yield debt. “Developing credit to, or increasing credit to, the private sector is extremely important,” says Angus Downie, head of research at Ecobank Capital, “but nothing is going to happen very quickly on that when you have large fiscal deficits that need to be plugged with short-term financing.” “A lot of investors are still looking to add African risk to their portfolios, because there hasn’t been a lot of it going around over the last few years”   According to data compiled by Standard Bank, African sovereigns issued a record US$16.6bn in 2013, but by August the flood seemed to be over. In July last year, Ghana issued US$750m of Eurobonds, which, while oversubscribed, seemed to demonstrate investors’ cooling interest for frontier debt. The coupon on the bonds was 8%, more than 100bp higher than the yield on a bond issue by tiny Rwanda two months earlier. In April, the yield on Ghana’s earlier 2017 bonds had traded as low as 4.25%. A year on, Sub-Saharan African sovereign issuance is on course to surpass the record set in 2013. Figures from Standard Bank estimate that total sovereign issuance stood at US$10bn on July 5. In July alone, Senegal, South Africa and Cote d’Ivoire came to market; the latter less than three years after it had undergone a major restructuring of its debt. In June, Kenya broke the record for a Sub-Saharan African sovereign issue, raising US$2bn. Even though the gloss has come off some of the region’s more compelling growth prospects, sovereigns have been able to raise billions of dollars. However, corporate issuance is still rare and companies in the region struggle to access finance. Questions also remain over whether recent Eurobond issuance is actually deepening Sub-Saharan capital markets. With high-yielding assets in higher-income emerging markets still depressed and developed economies still slow growing, investor appetite for frontier debt has survived talk of tapering and a putative slowdown in China, allowing Sub-Saharan African countries to price their issues at competitive rates. Cote d’Ivoire’s US$750m Eurobond issue in July was priced at 5.625%. As Megan McDonald, the global head of debt capital markets at Standard Bank, pointed out, the thin supply of Sub-Saharan debt means that each issuance is hotly contested. Although Eurobond issuance from the region has grown at a compound rate of about 34% for the past five years, it is still only around 5% of total emerging market Eurobond volumes. “That indicates a bit of a scarcity factor,” McDonald said. “A lot of investors are still looking to add African risk to their portfolios, because there hasn’t been a lot of it going around over the last few years.” McDonald admits that the low yield on Cote d’Ivoire’s July Eurobond offering was “quite surprising”, given the country’s recent history. Once the economic powerhouse of Francophone Africa, Cote d’Ivoire suffered de facto partition and civil war for two decades, culminating in a viol

A recent research report from Royal Bank fo Scotland makes grim reading. “The credit liquidity trap” points out that a European corporate bond issue now trades on average once a day by volume versus nearly five times a day just over a decade ago. It is no better in the US, where corporate bond trading volumes relative to the size of the market have been on a steady downward trend since 2005 and the US Securities and Exchange Commission shows that nearly 20% of corporate bonds do not trade at all. Corroborating the gloom of recent research notes, Jan Dehn, head of research at investment manager Ashmore, estimates that liquidity is down around 70% since the collapse in 2008–09. He is not entirely sympathetic. “It is entirely self-inflicted,” said Dehn, explaining that governments had undertaken regulatory changes and pursued banks as culprits. He called it a need “to satisfy the calls for blood lust”, but all this has done is “restrict banks’ abilities to take risks”. Blame The finger of blame must be pointed in particular at Basel III regulations. These have significantly increased the capital that banks must hold against almost all assets, but against emerging market bonds and corporate bonds in particular. Restrictions on proprietary trading by commercial banks instigated by the Volcker Rule have in all likelihood had an impact on the inventories of US banks too, but there are still some pockets of liquidity. “We are seeing liquidity in certain sectors – there is liquidity for Tier 1 and contingent convertible bond issuance, for example, thanks to hedge fund participation. We do see turnover there,” said Edward Stevenson, head of FIG debt capital markets origination at BNP Paribas. But these are the exceptions rather than the rule. “The regulations have biased the banks against trading anything other than government bonds. Debt with a higher regulatory cost is simply not being traded,” said Ashmore’s Dehn. Perhaps paradoxically, restrictions have happened at the same time that demand has increased, which has made the liquidity problem worse. “New capital regulations have come into force while the credit market has grown significantly over the last few years, with more new issuers and issues – increasing de facto the fragmentation of the credit world. All of this combined makes the liquidity even more challenging,” said Olivier Gazzolo, global head of credit at Societe Generale. With more investors chasing fewer issues, moans about the allocation process have become louder. One European syndicate head explains the dynamic of current deals. With a €500m trade it is not uncommon to see up to 600 investors fighting for allocations. The very best that one account could hope for would be €40m–€50m. Complaints about favouritism are perhaps inevitable, though unfair. “We have to be more transparent with allocations. Syndicate teams are just not in a position to favour their nearest and dearest,” said BNP Paribas’s Stevenson. A further effect of the new dynamic is that all of the action is in the primary market, with comparatively little happening in secondary trading. “Investors are going long into primary and sitting on it,” said SG’s Gazzolo, pointing that there is simply not the same incentive to turn over the book as there used to be. Stark decline The figures here too are stark. Corporate bond credit trading volumes might have remained stable in absolute terms at around US$20bn a day in the US for the last five years, according to figures from RBS. But while that might not have moved, the corporate bond market itself has grown by around 60% since 2007 to about US$9.8trn. As the bank points out, this means that daily volumes have gradually declined to around 0.2% relative to the size of the market. With buy-and-hold increasingly a necessity rather than a choice, investors might have expected some compensation for this lack of liquidity. But the premium for liquidity risk is close to pre-crisis lows across all fixed income m

Mario Draghi is a fan of securitisation. At the rates meeting on June 5, the president of the European Central Bank not only cut interest rates, he backed these up with renewed forward guidance on interest rates and a series of measures of credit easing aimed at supporting lending to the non-financial sector. Securitisation is being heralded as a potential remedy for many ills, specifically as the Holy Grail of SME funding. With a touch of asperity, in the discussion after the rates announcement Draghi said: “We are working on the ABS, but you know there are also other actors that would have to work on this, namely there has to be a re-visitation of the regulation that had been introduced in the past few years about ABS to eliminate some of the undue discriminations towards this specific product.” What the ECB is trying to do is to drive down the cost of the AAA component of the transaction. If that happens, then the all-in cost of selling the mezzanine and equity tranches becomes much more affordable. Securitisation is not only one of the more expensive assets, and not just in spread terms, but it is operationally intensive. It is this that makes it significantly less appealing than other forms of funding. This is as true from an investor point of view as it is from an issuer perspective. Securitisation is not an asset class that investors can decide to invest in without expensive infrastructure. Draghi is right to take aim at other actors, specifically Solvency II, the stringent capital-adequacy rules for insurers that will come into effect in 2015. They are significant, as insurers buy almost a third of securitisation paper. These new regulations are generally seen as the biggest bete noir for securitisation as they demand so much capital against securitisations that it ceases to be attractive. AAA tranches will have a risk charge of 2.1%, while the tranches below – AA, A and BBB – will have weightings of 3%, 4% and 5% respectively. This is an improvement, almost by half, on the initial proposals, but still challenging. That aside, scepticism still remains about how the ECB’s support for SME funding via securitisation might work in reality. Fitch has said that the changes will bring “little benefit to the largest and most active European securitisation markets”, while one banker calls Draghi’s plans “well intentioned, but inexcusably naïve”. Certainly volumes are significantly down in 2014. The first quarter of the year saw €18.5bn of issuance in Europe, according to the Association for Financial Markets in Europe – a decline of 43.6% on the same period in 2013. “These were post-crisis volumes to begin with. The securitisation market in Europe has become very modest,” said one banker. Securitisation bankers point to the UK’s Funding for Lending, which was adopted by the Bank of England in 2012 and ended in December 2013. The scheme, which had similar aims, saw bank lending concentrated on mortgages while lending to SMEs continued to decline. Indeed, the FLS saw a collapse in bank issuance across RMBS, covered bonds and senior unsecured debt. The challenge for the European banking sector at the moment, say bankers, is a lack of balance sheet capacity either as capital or leverage. This does make securitisation a unique tool. While all other forms of issuance provide funding, securitisation is the only one that provides funding, capital and leverage. “Eventually, I hope that the ECB will get round to saying what it means – that banks should be encouraged to remove assets from balance sheet by securitisation,” said one banker. To see the digital version of this report, please click here. To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

European and US rates policies have not seen a marked divergence since 1997–98. At that time, higher rates in Europe than the US triggered a shift of activity into Europe. The possibility of a similarly dramatic outcome to expected rates divergence has triggered lively debate across financial markets. Whether things will pan out similarly, but in reverse, partly depends on the basis swap market. But for the SSA market specifically, few expect much drama. “Rising rates are not always disruptive to the SSA market because after a sell-off has stabilised, what’s left can be a more favourable entry point,” said Lee Cumbes, head of SSAR origination for EMEA at Barclays. Issuers tend to be comfortable raising capital in whichever currency makes most sense at any given time, and in this market, in particular, there is always liquidity somewhere. The Fed is not expected to rush into its tightening cycle and will wait for confirmation that growth has taken root before risking choking it off. Growth is more established in the UK than in the US, said Zeina Bignier, global head of public sector DCM at Societe Generale, with good news interspersed with less impressive figures. And it is not just US growth at risk, raising rates too soon could undermine demand abroad and hurt US exports. It is clearly dangerous to put too much faith in the accuracy of these kinds of predictions: the market expected US rates to increase in 2013 before they fell further. But if the central banks’ policies do diverge in the second half of 2015 the situation could last for around a year before they come back into harmony, said Bignier. “By cutting rates the ECB has encouraged investors to look at different assets and even to extend along the curve,” said Cumbes. “Combined with other developments, we now see the range of issuance broadening, for example in the re-emergence of inflation-linked bonds, such as Italy’s first deal since 2011 and Spain’s debut in this market.” “Issuers can’t ignore the divergence of the central banks but there is not a lot they can do about this,” said Michaela Seimen-Howat at RBC. “Investors might become increasingly uncertain, given also the current tight spread levels, but SSA issuers are typically global issuers and they can be opportunistic in their issuance depending on where the demand is.” Issuers such as the EIB and KfW have such enormous funding programmes that they spread issuance out over the whole year. These issuers come most weeks, issuing wherever opportunities present themselves – in various currencies and tenors, as well as in the private placement market or via floating-rate notes, for example. “The big agencies have very diversified funding programmes and the profile of their issuance can vary strongly from one year to the next, depending on where the opportunities lie,” said Seimen-Howat. “This year we have seen a lot more sterling issuance, not necessarily because they needed sterling but because there was a lot of appetite in that market due to the supply gap created by the decline of issuer Network Rail, and because the cost was favourable.” While liquidity can shift between markets and currencies, demand is always strong for SSA paper, regardless of rates and risk appetite. Investors always want a bedrock of safe assets in their portfolio, even if they increase allocations to higher-yielding assets in the search for yield, and SSA paper is always likely to be at the heart of that. “The Treasury market may not return to previous notions of normal pricing until new issuance has seen the free-float in the market grow,” said Cumbes. “The Fed has bought a large amount of paper to-date. Regulation has also created new motivations for investors such as banks and money market funds to buy government assets, so this may help greater stability and a foundation for successful SSA issuance.” New global regulations on banks that force them to increase their liquidity buffers reinforce this trend and will continue to ensure

One of the many causes of the crisis was the inadequate levels of capitalisation at the banks. A solution to this problem has been the development of a new generation of hybrid instruments, such as contingent capital – CoCos – debt instruments that are either written off or turned into equity when a certain trigger is hit. Essentially, CoCos increase a bank’s capital buffer at less expense than equity. They are structurally riskier than other non-equity capital instruments, even than their pre-crisis forebears. But there is nothing shady about them, or immoral about banks selling them, insist bankers. “Their risks are fully disclosed in offering materials,” said Peter Jurdjevic, head of balance sheet solutions at Barclays. Europe’s enthusiasm for CoCos is in contrast to developments in the US, which has developed its own instruments to increase bank capital. “Compared with similar instruments issued by banks in Europe, US banks have been raising Additional Tier 1 capital using perpetual preferred securities, which have the advantage of being far simpler products,” said Nik Dhanani, head of capital solutions at HSBC. This is no small advantage: some bankers are quietly concerned that the complexity of these structures is leading regulation in the opposite direction of its stated destination. “While one of the aims of the new framework was to simplify capital structures, the final rules in some regions are in practice promoting greater levels of sophistication and complexity,” said one London-based banker. “This raises the potential for new layers of capital to be created.” Bespoke Part of the reason for the complexity is the highly bespoke nature of the products being issued, which banks argue must be tailored to suit their own very specific circumstances and requirements. This makes comparison between different issues very difficult. “The term CoCo has been used to describe various loss-absorbing instruments, and could mean different things to different people,” said Dhanani. “Generically, contingent capital securities are instruments that may be written down or converted into equity-based, on predefined triggers. With the advent of statutory bail-in frameworks, that definition suggests a wider range of unsecured liabilities are effectively CoCos. The only variable is the trigger and the severity of the loss absorption.” Yet pricing is failing to account for the significant differences that exist between products, which have different triggers and different outcomes once the trigger is hit. It also seems to be playing down differences in credit risk. Many peripheral names have been trading tighter to core European credits. Skeletons in the closets Banks such as BBVA issued with coupons of around 11.5%, reflecting the risk associated with such institutions at the time, but have now traded down to below 7%. Many in the market acknowledge that these levels have become detached from the true risk of the investment. Yet many also believe banks domiciled in core European countries such as Germany, France and the UK have skeletons that are yet to be revealed in their own closets, and considerable leverage on their own balance sheets. Structural peculiarities mean some hybrids look riskier than equity. For example, if buffer capital is approaching the trigger and shareholders know that trigger will see them get diluted, that might dissuade them from raising new share capital. Or if the trigger will see AT1 capital holders wiped out, shareholders may push the company towards that trigger out of self-interest, meaning AT1 is de facto junior to equity. This presents a can of worms of unintended consequences as shareholders look to game the system to protect their own interests above those of other parts of the capital structure. No sense in standardisation All of this would be easier to keep an eye on if products were more easily comparable, but a move towards greater standardisation of products does not seem to be on the cards. “AT1s we