Emerging market bonds are becoming respectable. Even – a few bankers and investors are daring to say – a conservative asset class.
They have been the best-performing fixed-income asset class so far in 2005, with a return on emerging market debt so far this year of 5.6% up to August, according to JP Morgan's Emerging Market Bond Index (EMBI).
It's not surprising, then, that cash has been flooding into the market in recent months. In July, more than $1 billion of new money was allocated to emerging markets, bringing the total for the first seven months of this year to $8 billion, according to JP Morgan. That compares to $4.8 billion during the same period in 2004.
Bankers believe that dedicated emerging market accounts are at their most overweight exposure ever. Which of course raises the question: can the party continue?
After all, whenever the Federal Reserve raises US interest rates, it has in the past particularly hit emerging market debt – witness the fall-out after rate hikes in the late 1980s and in 1994. And when new money pours in, it makes it difficult for the market to take a breather.
In March and April this year, emerging market investors felt the concerns that came from the downgrades of Ford and General Motors; there was selling off across the board. But many emerging market investors and investment bankers are convinced that things are different this time round – that the asset class remains fundamentally attractive.
Good recovery
"We think this contagion should not have taken place," says Raphael Kassin, head of emerging market fixed income at ABN Amro Asset Management in London. "So we got involved and bought some countries' bonds and watched them recover nicely." Kassin believes that fundamental conditions in emerging countries justify a further tightening of spreads to below 300bp over US Treasuries. However, he expects the spread tightening to occur at a slower pace than before.
Most emerging market countries are politically more stable and have larger foreign reserves than they did before. And since many sovereigns have already completed their financing for the year, Kassin argues that this is the time to buy emerging market bonds: "Don't forget that at the moment, some 45% of the bonds listed on the index are of investment grade. Eight years ago, when spreads were just as narrow, this percentage was below 20%." Having said that, it is much more important to choose countries in particular than to choose emerging market debt overall, advises Kassin.
In terms of valuation and the risk-return trade-off, emerging market bonds are cheaper and more attractive now than in 1997, while at the same time the financial position of some developed nations, notably the US and Germany, has deteriorated. That raises the novel concept of reverse contagion from developed to emerging markets.
Christian Stracke, an analyst at Creditsights, an independent research firm in New York, published a report in August that compared portfolio inflows into emerging market countries in the last year and where they stood in the years immediately preceding the Asia crisis in 1997. He concluded that countries were much less dependent, with stronger figures on average reserves, current account deficits or even in some cases surpluses. "We continue to consider emerging market spreads to be too tight, and we believe fair value is probably closer to around 100bp wide to current levels, but our survey of portfolio flows reinforces our belief that any sell-off in emerging markets should be relatively moderate and should not snowball into a full-blown crisis."
Compensation
The continued demand for high yielding assets should compensate for the rise in US rates – after all, they are still relatively low and in their search for higher returns, investors have also found themselves taking on more risk. Ironically, this has meant many are buying local currency bonds to increase their returns, which could in turn (or so the virtuous circle argument goes) bolster the credit quality of some emerging market countries as they reduce their exposure to US dollar debt – one of the critical causes of the Asian meltdown in 1997.
Despite the overall improved creditworthiness, everybody is aware that things can always go wrong. A mega-political scandal in Brazil, a potential impeachment in the Philippines, increased hostility in the EU against Turkey's membership – all such events risks could sharply impact on emerging market debt due mainly to the dominance of those countries as borrowers in the asset class.
Emerging market sovereigns have more or less completed their issuance for the year. There was expected to be a lot of new issuance in September. "It is a simple story: in the last few months people have not issued because they have pre-funded a lot earlier in the year," says Kassin. "At some point they have to start working for next year's funding. If the Fed keeps hiking rates, only the best credits will be able to fund at the optimum moment, which is why we will see the rush in September."
Brazil was expected to tap the market to pre-fund for next year. As 2006 is an election year, it has announced a $9 billion, two-year rather than a one-year funding programme. With the exception of Mexico, which has already covered 2006's amortizations, several other Latin American sovereigns are still to come. Venezuela has to raise $1.75 billion of its $3 billion funding needs for 2006; Colombia has $2 billion to raise in 2006 and Peru $1 billion.
In Asia, Korea Development Bank was due to tap the market in mid-September; the Republic of Indonesia announced a benchmark dollar deal, and the Philippines is always on the lookout for funds, with $850 million remaining on its 2005 funding requirement, having already raised $2.25 billion this year. In addition, the China and Korean sovereigns, as well as quasi-sovereigns like China Development Bank and Korea Export-Import Bank are due to approach investors by the end of the year.
Elsewhere, sovereign issuance is likely to be thin. Ukraine should have got a E600 million, 10-year deal away in mid-September, followed by the City of Kiev and Ukreximbank shortly after.
Romania might do a deal; Turkey will try and pre-fund for 2006 – market conditions permitting. Azerbaijan promises to launch a debut transaction next year. But most of the activity in the central and eastern Europe, Middle East and Africa (CEEMEA) region will probably be bank borrowing for capital requirement purposes.
"Emerging market bond issuance going forward is probably going to be a lot more bank supply rather than corporate supply," says Richard Luddington, managing director and head of origination, CEEMEA, debt capital markets at UBS in London. "Corporates are cash rich, although there is the possibility of some acquisition-related financing, whereas banks will tap the market for a mix of senior and subordinated debt."
Chris Tuffey, head of the emerging market syndicate at Credit Suisse First Boston in London agrees: "Most sovereigns are done for 2005, but some will pre-fund for 2006," he says. "What we will see is issuance from second-tier corporates and banks, especially with subordinated transactions."
Biggest and best in 2005
Emerging Markets looks at some of this year's key transactions
The year was less than two weeks old when the Republic of Turkey kicked off its funding programme with a landmark 20-year issue that raised $2 billion. Lead managed by Citigroup and Morgan Stanley, the deal attracted orders of $12 billion and effectively accounted for over a third of the country's overall annual $5.5 billion external borrowing requirement.
Less than a month later, the republic launched a E1 billion, 12-year issue via Deutsche Bank and UBS – meaning that over 60% of its target was raised in the first quarter. In June it added a $1.25 billion, 15-year deal. "These deals were significantly oversubscribed, and Treasury achieved its best ever sales and placement in Europe and among the US institutional investor base," said Memduh Aslan Akcay, director-general of the directorate of external economic relations at the Turkish Treasury.
The two other heavyweight sovereign emerging market borrowers were also notable issuers during the year. The Philippines launched a blow-out $1.5 billion, 25-year bond issue in January via leads Citigroup, Deutsche Bank and UBS. Coming to the market with a benchmark size deal at the long end of the curve marked a turnaround in the borrower's funding strategy. Previously it tended to issue little and often, but this new offering – the country's first long bond since 2000 – proved to be a must-have for emerging market investors.
Brazil is the third sovereign issuer, and this year's borrowing has been most notable for its successful exchange of $5.6 billion of outstanding Brady C bonds in July. Lead managed by Credit Suisse First Boston and JP Morgan, the swap allows Brazil to gain significant relief in its amortization schedule and rids the country of the stigma of its 1990s Brady bond programme.
From Russia, banks have dominated supply so far in 2005, and two subordinated issues by Sberbank and Vneshtorgbank (VTB) – the first lower tier-two Eurobond transactions from Russian issuers – were among the deals of the year. In February, Vneshtorgbank (through Barclays Capital, Deutsche Bank, HSBC and JP Morgan) and Sberbank (UBS) raised $750 million and $1 billion respectively.
The Russian banks brought a new instrument to the market and accessed a new investor base, as well as providing beneficial spin-offs to the economy by strengthening the banking sector as a whole.
Perpetual frenzy
Awash in cash, Asian investors are snapping up Latin perpetual bonds with abandon. Where else will they park their money?
While Asian central banks prop up US Treasuries and buy other triple-A rated bonds, cash rich Asian retail investors have triggered an astonishing new market in perpetual bonds from Latin America.
With private banks in Asia holding assets of $6 trillion to $8 trillion – and with few obvious places to park their money – Asian investors have for a couple of years been busy buying short-dated bonds from the likes of Kazakhstan and Russia. In the last year, they have added perpetual bonds from Brazil and Mexico to their shopping list.
Pemex, the Mexican oil producer, kick-started the market last September when it launched a ground-breaking $1.75 billion, 7.75% perpetual non-call five-year bond targeted at Asian retail investors.
Lead managed by Citigroup, HSBC and Merrill Lynch, it was the largest unsecured corporate bond ever issued in Latin America and the largest ever perpetual issue by a corporate borrower. It was also the first transaction of its kind to tap into an entirely new investor base in Asia.
Asia took 65% of the deal, with retail investors and private banks accounting for 75%, fund managers and insurance companies 13% and banks 12%.
It was an extraordinary sign of the amount of cash awash in Asia, and it ushered in an issuing frenzy from Latin America. For an issuer, selling perpetual bonds is the next best thing to equity, and it can also retain a call option.
In December, Gruma, the Mexican tortilla producer, sold a $300 million, perpetual non-call five-year bond that attracted more than $1 billion of demand globally, with nearly 40% going to Asia.
In late May, Brazil's Banco Bradesco issued the first ever tier-one capital issue rated speculative grade, a $300 million, perpetual non-call five-year bond. A month later, Braskem, a Brazilian chemical company, sold a $150 million, perpetual non-call five issue that attracted such overwhelming demand from Asia that it was priced a week early – with the European road show ditched – as Asians comprised 85% of the book. It was the first ever corporate non-investment grade true perpetual.
The typical issuers of perpetuals are investment grade banks and companies, but Bradesco and Braskem opened up the market for speculative grade issuers.
Perhaps the biggest blow-out deal came in July when CSN, the Brazilian steel company, attracted orders of $2.3 billion, with almost half coming from Asia. It raised $500 million and then stunned market participants by reopening the deal by $250 million a week later.
A flood of issues is expected. Telemar, Brazil's biggest fixed-line telephone operator, announced in September that it was looking to issue a perpetual bond targeted at the Asian retail base. It joined a Brazilian list that included Odebrecht, the construction conglomerate, Santander Banespa, and Gerdau, a steel company.
Bankers agree that the next stage in the development of the market is the arrival of issuers from outside the Latin American region – from areas like eastern Europe, especially Russia.