Ask emerging markets bankers how investor risk appetite has changed since the crisis and the likely response will be: "Which crisis?" In a market that over the past two years alone has witnessed in rapid succession a near-default in Dubai, the fallout from Europes peripheral convulsions and political turmoil in the Middle East and North Africa, the collapse of Lehman Brothers now seems light years away.
Yet while memories of the global financial crisis may be fading, its legacy lives on in the developing world. The remarkable resilience of many emerging economies to the global turmoil of 2008/9 helped to convince investors that a paradigm shift was indeed underway, and ultra-low interest rates in the developed world provided the necessary spur to expand into new markets.
Since then, the migration of capital from developed to developing markets has seemed almost unstoppable and has certainly proved impervious to the woes of western Europe something Nick Darrant, head of CEEMEA bond syndicate at BNP Paribas, says would have been inconceivable before the credit crunch. "Previously whenever a financial crisis hit, those worst affected tended to be emerging markets. Now were going through a eurozone sovereign crisis, a US fiscal crisis is looming and yet you wouldnt notice it if all you did all day was watch emerging markets."
Indeed, far from dousing investor enthusiasm for emerging market assets, recent first world traumas have stoked it. "The increased risk appetite hasnt abated despite the sovereign crisis in Europe if anything the rationale for diversifying your holdings, whether its in sovereign, financial or corporate paper, is increased by whats gone on in Europe over last nine months," says Robert Whichello, global co-head of syndicate at BNP Paribas.
That is not to say, of course, that emerging markets have been completely insulated from shocks over the past two years. When state controlled investment vehicle Dubai World announced in November 2009 that it intended to ask for a moratorium on its debt and that of its real estate subsidiary Nakheel, it sparked a panic among investors who had assumed that Abu Dhabis oil wealth would support any weaker credits with government ties in its smaller neighbour.
In the event, however, the fallout was remarkably brief. Abu Dhabi did step in, bondholders were supported and the only real losers were the loan providers, most of whom were philosophical about taking haircuts and agreeing rescheduling in the interests of long-term relationships in a valuable market.
Indeed, many investors saw the Dubai World incident not as an intimation of the vulnerability of emerging markets but as a timely reminder of the importance of not making assumptions about the extent of support for state-controlled entities. "Dubai World has forced people to look for more disclosure," says one senior emerging market syndicate banker.
Whichello agrees that investors have since done much more due diligence on individual credits, particularly when state support is involved. "There is more focus on how close to the state a state owned entity is," he says. "You can be 100% owned by the government and have entirely different levels of proximity in terms of how key to the economy that entity is. If its a corporate thats 60% government owned thats great but investors want to understand the credit, because as weve seen sovereign support isnt always what it looks like."
What the Dubai World incident did prove, though, was that while investors might need to pay more attention in assessing individual credits, they were already differentiating far more than before between, and even within, regions. "Dubai World caused volatility to GCC credits but it was short lived and there was no contagion to other countries in the CEEMEA region," says Whichello. "The majority of investors took this short term repricing as an opportunity to increase their exposure to countries such as Qatar and Abu Dhabi."
This trend was also exemplified by investor reaction to the disruptions in the Middle East and North Africa (MENA) this year. Although the debt of Egypt and Bahrain took a battering, much of the money that exited the troubled economies stayed in the region, with credits in Qatar, Abu Dhabi and Dubai seen as safe havens by investors.
Indeed Alan Roch, syndicate director at Royal Bank of Scotland, says that the relative lack of capital markets activity in the region this year is due to supply-side constraints rather than lack of investor interest. "There is a huge demand for Middle East paper due to the lack of any meaningful recent supply. Many investors feel the time may not be right yet the investor demand is clearly there."
The success of two recent issues from Abu Dhabi borrowers amply demonstrated this. Even as disturbances continued across the region, the International Petroleum Investment Co (IPIC) brought a jumbo triple-tranche euro and sterling deal worth more than $4.3bn in early March, while state owned investment company Mubadalas $1.5bn dual-tranche issue in mid-April was more than four times oversubscribed.
The success of the IPIC deal also highlighted another new aspect of the evolution of risk appetite in emerging markets, in that it was primarily denominated in euros and marketed to western European investment grade funds. "The IPIC trades a great example of a GCC credit accessing euro investors, which for that sort of size one wouldnt have expected to see that before the crisis when investors would have preferred to focus on European peripheral credits," says Whichello.
Beyond traditional boundaries
This, of course, is not solely a Middle Eastern phenomenon. With high grade corporate paper in Europe under heavy demand pressure, investment grade buyers have been increasingly looking further afield for better returns. "Spreads for corporates in western Europe have tightened in so far that investors are continuing to go down the credit curve and raise their risk appetite to maybe get exposure to a corporate that they probably had limited exposure to before," says Whichello.
Roch at RBS agrees. "Investment grade borrowers obviously attract investment grade credit funds beyond EM dedicated funds. Many such funds have increasingly been looking at participating into IG deals that have been originated from emerging markets."
This move by investment grade buyers has, in turn, forced traditional emerging market fund managers even further down the corporate credit curve. As Darrant at BNP Paribas explains: "Traditionally emerging markets is an asset class which is top-down and sovereign-focused but theres an element of the asset class which has become a lot more bottom up and is looking at much more credit-intensive stories which are rated many notches below the sovereign. This is the area the traditional emerging market investors are sinking their teeth into because thats where you get real value and maximum exposure."
At the other end of the risk spectrum, the past year has also seen tentative moves by rates investors into high-end emerging market sovereign names, particularly in central and eastern Europe. "You increasingly find that theres a juxtaposition of investor bases in many new issues, particularly in CEE," says Roch. "Some countries have fully migrated away from EM already the likes of the Czech Republic and Slovenia driven by their strong single-A rating are closer to the SSA investor base and as spreads compress the likes of Poland are also benefiting from both investor bases."
This is far from a new phenomenon. Before the financial crisis these economies were seen as convergence plays and their sovereign debt was predominantly bought by public sector banks in western Europe at levels barely above those of Germany. Thus, while the 150bp over swaps that Poland paid for its Eu1bn 10 year issue in January this year may compare favourably with the 280bp premium demanded for Eu750m of five year funding in May 2009, it is still a long way from the 15.5bp over swaps that the sovereign achieved for its Eu3bn 10 year note at the start of 2006.
This fundamental repricing of risk in an economy that is seen as one of the strongest in the region clearly shows that, while SSA investors may be happy to dip their toes into CEE, their enthusiasm for the market is not comparable with that of pre-crisis regional stalwarts such as Depfa, Eurohypo and the German Landesbanks. Similarly, the fact that Polands larger issues now regularly attract order books of 300-400 individual accounts may reflect a welcome diversification of the investor base, but it also indicates that big-ticket buyers are few and far between.
Given the strength of many CEE economies relative to those in peripheral and even core Europe, this cautious approach might seem surprising. Yet as one syndicate official points out, in view of the depreciation and volatility of currencies such as the zloty and forint in the wake of the financial crisis, investors preference for eurozone economies is understandable.
"CEE economies are increasingly being seen in a developed, first world light, but until they are part of the same currency union its going to be tough for first world portfolios or central bank portfolios, the biggest buyers, to consider them in exactly the same light," he says. "Capital flight can have implications for those countries in a way that we still dont think will apply in the eurozone for now."
CEE sovereigns also suffer paradoxically from the fact that even for the larger economies thanks to low levels of leverage and healthy domestic demand their annual funding requirements are well below those of some weaker western European names.
"The type of investors that buy, say, Belgium need liquidity, they need very big funding programmes with absolute clarity on when borrowers will come to market, how frequently and in what sizes," adds the banker.
"A lot of the guys buying SSA product will need to see $2bn-$3bn deals and that would be one deal for Poland a year. And if Poland does a $3bn deal but it only does one a year, youre not going to get the guys who need a $3bn deal to invest in it because they also need a curve and they need to know theres going to be regular issuance. So until the CEE sovereigns have grown to that point the liquidity dynamic will keep them out of certain core portfolios as well."
Another aspect of this liquidity trap is the lack of support for CEE credits, compared with other options in both the sovereign and agency spaces. SSA investors have historically been happy to overlook the lack of liquidity in agency names due to their role as sovereign subsidiaries, and since the establishment of the various eurozone support mechanisms this perception has been extended to smaller members of the single currency area.
"The lack of liquidity at a notional level in some SSA specific borrowers is covered by the broader umbrella above them," says another syndicate official. "Investors might say I dont feel particularly strongly about Luxembourg but I do know all about Europe and I do understand the mutual funds being available to all of them, the way the European Financial Stability Facility works and so forth so Ill look at it as a pick-up relative to other places, but if you look at Poland there is no greater institution."
Despite all this, however, some bankers say the caution is being overdone and that SSA funds need to make a more fundamental shift in attitudes to risk to reflect the changed global, and particularly European, economic environment. "Many of the current fund differentials are based on traumatic events of fund managers early years that if they were looked at again in the cold light of day were very different markets from what were in right now," says the banker.
"Thats particularly true within CEE in those countries youve now got fully established political systems and rights of property law, and youve got fiscal and monetary conditions which bar independent currencies are far stronger than much of those within the eurozone."
Nevertheless, he adds, persuading fund managers to make that shift is likely to be a very gradual process. "You cant say to someone Your entire portfolio is fundamentally missing out and you should now include Abu Dhabi, Poland, Hungary and China for the following three reasons," he says. "What we do is say, Were doing a transaction for Hungary, heres how their credit compares to people you currently buy, heres how the liquidity compares, isnt it time you considered at least trialling Hungary within that bigger portfolio?"
Yet, while it may be frustrating for higher grade names to be lumped in the emerging bracket, the necessity for many of exploring new currencies and tapping new investor bases has been a key factor in the remarkable recent stability across the asset class. "The depth and granularity of new-issue orderbooks today is much greater than it was pre-crisis," says Roch at RBS. "When speaking about the period earlier this year during which there were outflows in hard currency EM, its important to understand which sub-set of the investor base these outflows were relevant to. We believe these were more retail as opposed to institutional, and clearly the trend across the sub-sets has reversed since."
What is more, while a lack of liquidity may limit the penetration of some CEE sovereigns into SSA portfolios, many emerging market credits with low funding requirements are seeing spread compression as inflows into EM funds remain at record levels. "Many of these countries dont need very much money and thats having an impact on spreads, as investors are having to chase bonds in the secondary market," says Darrant at BNP Paribas. "The smaller deals in particular are tightening considerably because investors cant put all their money to work in secondary markets."
In turn, he adds, this should encourage more names to access the debt capital markets, leading to even more choice for investors. "Its a dynamic that is clearly very supportive for primary issuance and theres a realisation on the part of many issuers for whom the bond market wouldnt have been on the radar screen in years gone by, but it is now," he says. "They recognise it as a viable funding alternative."
As with all asset classes, there is still the question of what will happen to emerging market debt when QE2 comes to an end in June. But Roch at RBS argues that, while there may have been some acceleration of inflows into emerging markets due to the low interest rate environment in the West, there has also been a fundamental aspect on investors appetite for growth regions.
"Our view is that the flows that have gone into emerging markets are by and large sticky flows they represent a genuine re-orientation of asset managers into that asset class, which is unlikely to shift materially on a short-term horizon despite a potential interest rate landscape change in the US," he says.
As he points out, despite the big inflows of the past three years, investment opportunities in emerging markets are still trifling by comparison with those in the developed world the eurozone for example needs to refinance around Eu900bn in the sovereign space alone this year, compared with $300bn of issuance across all emerging markets last year. "So theres a natural fundamental catch-up and you see that clearly in primary markets as the largest asset managers have taken a conscious decision to expose themselves much more to not only the BRICs but much more broadly into emerging markets," he says.
While emerging markets will clearly never be immune to shocks, whether external or internal, the combination of this growth potential with investors increasing ability to differentiate between regions, countries and credits suggests that talk of a new risk paradigm might not be entirely premature. And the more buoyant the markets, the more borrowers will benefit, as Darrant at BNP Paribas points out.
"Its a natural progression," he says. "As the markets continue to show strength, investors have the confidence to move the needle on their risk-reward spectrum."For many, the distance that needle has already moved since the dark days of 2008 is ample proof that the shift in investor perception of emerging markets is here to stay.