Pushing the boundaries of developing market debt

Buoyed by global demand for higher returns, frontier markets have so far shrugged off setbacks such as the MENA crisis and Belarus’s currency devaluation. But could the end of quantitative easing in the US finally crimp investor appetite for the high risk end of the EM spectrum? Lucy Fitzgeorge-Parker reports.

  • 25 May 2011
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What do you do when a new buyer base starts moving into your territory? That’s the question traditional emerging market investors have been asking over the past two years as western European fund managers, hungry for yield in an environment of ultra-low interest rates and anxious to avoid the troubled eurozone periphery, have begun to turn their attention to investment grade names across central and eastern Europe (CEE) and the Middle East.

In many cases, the answer has been to move further down the credit spectrum. Thus in strong developing economies such as Russia, Poland and Abu Dhabi, where top-tier names are now finding their way into investment grade portfolios, EM fund managers are focusing on far more credit-intensive corporates, sometimes many rating notches below their traditional sovereign or quasi-sovereign targets.

But it is not all about drill-down within the more developed growth markets. There is also appetite for issuance from a new generation of frontier markets, as evidenced by the fact that — despite the market convulsions caused by the Greek and Irish crises — three European sub-investment grade issuers made their debuts in the international bond markets last year.

First up was Belarus, which priced a $600m five year issue at the end of July 2010. Such was the extent of demand for the former Soviet republic’s first Eurobond that the bookrunners were promptly able to tap the deal for a further $400m. The sovereign came back for $800m of seven year funding in January — a deal that was priced at 627bp over Treasuries, 100bp tighter than the previous issue.

Joining Belarus in the international markets, although on a rather smaller scale, were Balkan neighbours Montenegro and Albania. Both sovereigns had been looking for a suitable issuance window since the end of the financial crisis and finally found one as bond markets opened up in the autumn. Montenegro got off the mark with a Eu200m five year deal in September and six weeks later Albania came with a Eu300m issue in the same tenor.

Outside Europe, new sovereign issuers have also seen considerable demand over the past 12 months. Jordan attracted more than 220 individual accounts for its $750m five year note in November 2009, and the trend continued into 2010 with the arrival of another long-awaited debutant — Nigeria. The sovereign priced a $500m 10 year deal on January 21, paving the way for UK-domiciled Nigerian oil and gas explorer Afren to bring its own first issue, a $450m five year, a week later.

The past year has also seen the return to the market for the first time since the financial crisis of a series of rarely seen sovereign issuers. Egypt received widespread plaudits for the timing and execution of its $1.5bn dual tranche 10/30-year deal in April last year, which was priced at a healthy 200bp and 233bp over Treasuries respectively and, in notable contrast to Russia’s jumbo $5.5bn deal struck on the same day, performed well in the aftermarket despite the increasing nervousness surrounding Greece’s economic woes.

Fellow North African sovereign Morocco followed in September, making its third Eurobond appearance with a Eu1bn 10 year, while Georgia’s return to the market in April this year for the first time since the war with Russia in 2008 eloquently testified to the continuing depth of investor demand for riskier assets. The single-B rated Caucasian state priced its $500m 10 year deal at 365.5bp over Treasuries, just 65bp wider than the $3bn issue of EU member Hungary a fortnight earlier.

The range of this new issuance demonstrates both the breadth and flexibility of investor demand, given that many of the deals failed to tick investors’ traditional boxes. While some borrowers, such as Belarus and Georgia, benefited from the inclusion of their issues in EM bond indices, for which the main entrance criterion is a minimum deal size of $500m, smaller deals also found ready pockets of demand. "Index eligibility is a sweetener but it is clearly only part of the process of evaluating a credit," says Nick Darrant, head of CEEMEA syndicate at BNP Paribas.

Similarly, traditional EM wisdom has it that where possible the sovereign should enter the market before corporates from that jurisdiction. Darrant explains: "Issuance by the sovereign isn’t a prerequisite for frontier market corporates to issue but it is to the benefit of the issuer because it sets a floor and allows investors to value the credit as a function of the sovereign plus a spread. Without the sovereign there you effectively have a debate over where the sovereign should be and a debate over where the spread over the sovereign should be."

Yet in the case of Afren several market participants dismissed the Nigerian sovereign’s contribution as irrelevant, given the tenuous links between it and the UK-listed corporate, while quasi-sovereign credit the Trade and Development Bank of Mongolia brought a $150m three year issue off its EMTN programme in October and buyers are still waiting for the sovereign’s Eurobond debut.

"The Mongolian development bank deal is a clear indication of how strong the market is when that entity can print a trade when there’s no sovereign reference point and there’ll be very little research written around the jurisdiction," comments one syndicate official.

An even more striking example of this phenomenon was the first appearance, in February this year, of Azerbaijan State Railways. The state-controlled issuer priced one of the first ever deals from the Caucasian republic, a $125m five year note, without the benefit of either a sovereign reference point or a rating (although the deal conditions specified a coupon penalty if the latter was not obtained in due course).

Investor appetite for some of these names has been unsurprising, in that they are seen as a play on rapidly rising commodity prices. "Places like Kazakhstan, Mongolia and even Azerbaijan have really benefited from the commodity boom and there aren’t many assets out because they haven’t needed to issue much debt, so there is a thirst for those sorts of assets," says Gabriel Sterne, senior economist at frontier market investment banking boutique Exotix.

Yet the fact that enthusiasm for frontier market names is not entirely due to demand for commodity exposure is amply demonstrated by the ease with which Georgia — a country with no natural resources and little industry — found mainstream EM buyers for its most recent issue, a result that one EM banker describes as "astonishing". "Georgia has caught the world’s attention because it’s seen as having very open markets and low corruption," he says. "But this is a pretty poor country, it has a GDP per capita of $2,560 and it’s just had a war with Russia."

Cautionary tales

But if the deals of the past year have shown that frontier markets have reaped the benefit of global appetite for EM credits, they have also served to remind investors that this is still a high-risk asset class. The most high profile convulsions have been in the Middle East and North Africa, where bond investors in Egypt and Bahrain — which priced only its third international issue in March 2010, a $1.25bn 10 year — took a battering during the troubles earlier this year.

Elsewhere, Belarus has also been a cautionary tale. The announcement in mid-March by the country’s central bank that, due to rapidly declining reserves, it was halting sales of foreign currency sent bond yields soaring as markets priced in a devaluation of the rouble and Standard & Poor’s downgraded the sovereign rating one notch to B. Yields on the freshly minted seven year note went as high as 12% before stabilising in mid-April when the central bank allowed the rouble to depreciate.

Yet while these upheavals might have been expected to dampen investor appetite for frontier market debt, so far this has not been the case. On the contrary, Sterne at Exotix says, they have instead demonstrated the lack of correlation between these markets and thus the genuine diversity they can offer for portfolios.

"One of the beauties of frontier is that diversification is very much possible in the sense that risk is often country-specific — the risk in Ivory Coast is related to the civil war there, in Belarus it’s related to Lukashenko and his autocratic style, in Venezuela it’s Chavez — so you can diversify this risk in a way that is more difficult in more advanced economies where global effects are more prevalent," he says.

This has been most notable with the MENA troubles. Not only did these fail to hit investor sentiment around other emerging markets, but even within the region any contagion was remarkably brief. By the end of April, average spreads on MENA sovereigns were lower than at the start of the year. This could be partly put down to continuing high oil prices. Indeed, one banker describes the results in the region as "Oil 2, Disruptions 1". Yet non-producer Dubai rallied strongest through March and April.

Nevertheless, as Sterne acknowledges, there are some external shocks that even frontier markets may not be immune to, most notably the end of quantitative easing in the US in June. The effect of this in the frontier space could be twofold. Firstly, there is the more general fear that rising interest rates in the developed world will divert investors from riskier assets elsewhere, a phenomenon that bankers report has been in evidence over the past year.

"We’ve seen both in prices and in talking to our clients that the impact of QE2 and the effect of creating global liquidity actually filter through quite quickly into EM and then frontier markets," says Sterne at Exotix. "What we often see is market sentiment veering between ‘risk on’ and ‘risk off’, and that has a very quick effect on frontiers."

More specifically, if US rates begin to edge up, frontier markets may lose part of their new investor base. With very low returns on domestic corporates, US high yield crossover funds have been happy to branch out into frontier credits, but in a rising rates environment EM bankers predict some of that money may repatriate. "As money has poured into these funds over the past couple of years they have been very keen to look into the frontier space but as QE comes to an end and maybe US interest rates go up that might affect EM and therefore frontier markets," one comments.

Finally, of course, if global growth fails to live up to expectations or the Chinese boom proves to be a bubble, then frontier debt could quickly lose its appeal for investors. As Alan Roch, syndicate director at RBS, points out: "If the market were to become defensive then some of the weaker names that we have seen are going to find it more difficult."

While risk appetite remains at high levels, however, it seems likely that more and more frontier borrowers will opt to tap into demand for their paper. Georgia’s government is reported to be planning a second Eurobond this year to take advantage of the extraordinarily cheap funding on offer, and several quasi-sovereigns are also said to be on the verge of issuance — Bank of Georgia in particular has long been discussing a follow-up to its 2007 deal.

Elsewhere, Macedonia has had a mandate outstanding since May last year and may finally return to the bond markets in the coming months. Even more probable is the long-awaited debut from frontier market star Mongolia. Riding high on the back of the commodities boom, the central Asian state saw its tiny stock market beat the second-best performer globally last year by more than 50% and pricing for the sovereign would undoubtedly be favourable.

Market debuts are also mooted for more sub-Saharan African sovereigns. The region is generating investor interest, as evidenced by the popularity of local currency private placements (see box), and several countries are expected to revisit issuance plans that were put on hold in the aftermath of the global financial crisis. Kenya’s government stated in a letter of intent to the IMF in January that it was planning a sovereign bond in fiscal year 2012/13, with the likelihood that the deal would come earlier in the period "to take advantage of the favourable interest rates".

Angola is also cited as a potential sovereign issuer. Originally announced in August 2009, a $4bn sovereign issue has yet to materialise — so far the only deal outstanding is one small, semi-private placement — but the sovereign received ratings from all three agencies in May last year and bankers report that the time could be ripe for a public debut. "Yields have come down a bit on Angola so maybe they’re thinking now’s a good time to benefit from the commodity boom and issue," says one.

Similarly, Zambia’s finance minister said in December that plans for a $1bn sovereign issue, postponed since 2008, had been revived. The announcement in March that Africa’s largest copper producer had secured a rating from Fitch enhanced expectations that it would not be long in coming to market.

With no sign in the slowdown of inflows into EM funds and fewer options for investment in traditional growth markets, it seems likely that this year will be a bumper one for frontier issuance.

 Keeping it private  
 For mainstream investors eager to see new bond market entrants from the EM frontiers, the fact that private placement activity has been picking up should be good news.

"One of the very early stages of a frontier market opening up is the private placement market, where a bank will structure a transaction for a fairly modest size and place it with a smaller group of investors who have a developing interest in that country, and that often precedes any kind of public large benchmark transaction," says Nick Darrant, head of CEEMEA syndicate at BNPP in London.

This bespoke and illiquid market covers a vast spectrum of formats and risk factors. Borrowers are typically unrated but can range from unsophisticated corporates that do not have the capacity to produce the types of information required by rating agencies to national champions that are as yet unable to meet all the disclosure requirements for public bond disclosure.

If the issuers are unsophisticated, however, the investors are anything but. Primarily comprised of a handful of EM dedicated hedge funds in London and New York, they are characterised by a willingness and ability to do extensive due diligence in some of the world’s most challenging economies. As one market participant puts it: "You can’t invest in onshore Nigeria if you don’t have an in-house view on Nigeria, and you need to have a ground level view."

The appeal of these instruments for investors is that, due to the lack of transparency and visibility, yields are much higher than can be obtained in the public markets. The transactions are equally rewarding for DCM bankers, more and more of whom have begun searching out opportunities across the globe as demand has rocketed over the past couple of years.

The catch, however, for mainstream investors who would like to see where the smart money is going is that it is one market where private means just that. None of these deals makes it on to screens, and banker paranoia about protecting client confidentiality even extends to the number of investors in the market — "dozens" is the nearest one will come to committing himself.

Such reticence applies equally to the names, jurisdictions and sometimes even the regions of borrowers. In CEEMEA, however, the focus is said to be on sub-Saharan Africa, although one senior banker adds that "transactions of this nature are being done up and down the African continent" and central Asia, with a low level of activity also reported in other CIS countries and central Europe.
  • 25 May 2011

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 103,566.27 417 8.26%
2 Citi 97,853.47 366 7.80%
3 Bank of America Merrill Lynch 83,395.10 317 6.65%
4 Barclays 83,385.96 297 6.65%
5 HSBC 66,419.68 329 5.30%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Bank of America Merrill Lynch 9,641.73 19 8.93%
2 Deutsche Bank 6,437.48 16 5.96%
3 Citi 6,198.13 15 5.74%
4 BNP Paribas 6,032.35 28 5.59%
5 Commerzbank Group 5,686.13 23 5.26%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 2,328.59 11 11.00%
2 Morgan Stanley 2,132.71 13 10.07%
3 Bank of America Merrill Lynch 1,598.67 7 7.55%
4 JPMorgan 1,544.99 8 7.30%
5 UBS 1,229.93 7 5.81%