Despite a surge in bond issuance across central and eastern Europe, the gulf between supply and ever-increasing investor demand for debt remains vast.
Nowhere is the dearth of supply as evident as in the region’s corporate debt markets.
Worldwide, the corporate emerging market debt asset class is worth roughly $730 billion and could reach $1 trillion within the next three years, according to Ashmore Investment Management.
But of the six largest country constituents of the JP Morgan corporate emerging bond market index, Russia is the only one from the CEE region, with Brazil the largest and Hong Kong, Korea, Mexico and China ranked third to sixth. Russia is weighted second, thanks largely to its national champions in the oil and gas and banking sectors.
“Outside Russia, the number of corporate issuers from CEE jurisdictions has been small,” says Jonathan Segal, head of Ceemea debt capital markets origination at Barclays Capital in London.
Gleb Shpilevoy, credit analyst at Raiffeisen in Vienna, points out that in terms of total bonds outstanding, the emerging market corporate credit asset class represents 91% of the total emerging sovereign eurobond market. “In terms of relevance, sometimes corporate bonds are the only opportunity to take exposure to the country risk, which is the case in Kazakhstan, where there is no outstanding sovereign paper,” he says.
But so far, issuance volumes have proved disappointing. The hope now is that a retreat from lending by banks in emerging markets could prove a boon for regional bond markets.
“A clear trend in the Ceemea region is that financing is becoming more and more dis-intermediated,” says Saleh Romeih, head of Ceemea capital markets and treasury at Deutsche Bank in London.
Before the crisis, global syndicated lending to emerging market borrowers stood at roughly $600 billion, three-quarters of which was provided by western banks, notes Romeih. “Not only have syndicated lending volumes since then dropped quite sharply, the share of lending by banks from developed economies is probably about a third of what it used to be,” he says.
“With emerging market economies growing, but with banks in developed countries under pressure to reduce their lending even more as Basel III kicks in, the financing gap will widen. Increasingly, bond finance will be the most efficient way of filling this gap.”
The divergence between developed and emerging market bank lending could prove a critical variable in the development of corporate bond markets.
Perversely, the strength of the domestic banking industry could act as a constraint on the growth of corporate bond markets. This is especially so in Turkey, where “issuance opportunities in the corporate space have been limited because the banking system is so strong,” says Romeih. “Local banks have a tremendous amount of liquidity to lend to the domestic corporate sector.”
The same is also true in Russia, where top-tier companies can access ample cheap funding from banks and see little need to pay higher rates for bond financing. Nevertheless, “all top-tier Russian corporates now access the capital market as a matter of prudent financing management.”
Even in markets with high levels of local banking liquidity, non-sovereign issuance has considerable room to grow.
First, bank lending, while plentiful, tends to be short term compared to bond financing. “Turkey’s bank lending market is phenomenally liquid at present, and borrowers looking for shorter tenors won’t consider going to the bond market when short-term bank loans are so cheap,” says Fergus Edwards, global head of emerging markets syndicate at UBS in London. “But smart borrowers in Turkey are increasingly looking to the bond market as a means of adding tenor to their funding mix.”
Second, borrower demand for foreign currency could act as a spur for bond issuance. Russia’s Sberbank, for example, saw its US dollar funding position depleted in the second half of 2010. “The lender was committed to disbursing large-ticket dollar-denominated loans to several Russian blue chips, while retail depositors – the core of Sberbank’s funding base – had been reallocating their savings from hard currency into roubles.” The same note adds that “we do not see any incentive for the population to save in dollars this year, given the bullish outlook for the rouble, so the bank will probably have to resort to capital market borrowings.”
CONSOLIDATION
Corporate consolidation could be another important driver of future non-sovereign bond issuance in the region.
Bankers say that Russia offers the most scope for mergers and acquisition activity in the region. This is especially so in its financial services sector: Russia’s banks face a doubling of their minimum capital requirement from Rb90 million to Rb180 million in January 2012.
“This provides smaller institutions with the incentive to merge with (or acquire) other banks in order to jointly meet the higher requirements,” ratings agency Moody’s noted in a recent report. “Regulators have also paved the way for more M&A [mergers and acquisitions], by easing the administrative requirements for bank mergers in 2010.”
Some of the expected consolidation will be cash-funded, but industry analysts also expect the ready availability of debt to drive Russian banking mergers. “The conditions are in place for M&A activity to gain momentum in Russia,” Moody’s comments. “Banks have the means to finance deals, evidenced by a high share of liquid assets and increased access to debt financing. Many banks also have excess capital, which they are looking to utilize. Lower M&A valuations following the crisis combined with accelerating credit growth also stimulate M&A demand.”
Sberbank is one bank known to be on the hunt for potential acquisitions in the CIS, central and eastern Europe and Asia. According to Raiffeisen, the Russian bank is rumoured to have eyed Bank Zachodni in Poland, BTA Bank in Kazakhstan, the international division of Austria’s Österreichische Volksbanken AG Group, Garanti Bank in Turkey as well as Troika Dialog in Russia, the only concrete acquisition to have emerged so far.
A broader wave of corporate activity could also drive further bond issuance. Jonathan Brown, head of emerging market syndicate at Barclays Capital in London, points out that it was M&A of this kind that drove a successful $1.5 billion, dual-tranche deal in January for VimpelCom, the Russian telecoms company. Although the proceeds of that deal were officially earmarked for general corporate purposes, this may include some of the cash consideration for VimpelCom’s acquisition of Wind, the Italian telecoms company.
Although nominally an emerging market company, “VimpelCom will move into the top five mobile telecom companies in the world when the acquisition is complete,” says Brown. Orders reached $3 billion for the $500 million, five-year tranche and $4.5 billion for the $1 billion, 10-year bond.
SOME POTENTIAL
Issuance further down the credit curve has been in even shorter supply, although bankers are hopeful for a pick-up in activity. “There is some scope for high-yield issuance arising from private equity activity and from privatization programmes in countries like Poland, which are attracting the attention of private equity investors,” says Dominique Lemaire, head of high-yield and hybrid capital markets at UniCredit.
Companies across the region are by and large in better financial health than their over-leveraged western European peers. According to Erste, “CEE companies are significantly less indebted, more profitable, have higher operational efficiency and generate a double return on capital compared to western Europe.”
That could suggest that there is plenty of capacity for corporate borrowers in CEE to take on more leverage. But equally, it could mean that CEE companies are naturally debt-averse and more likely to fund acquisitions out of cash.
Even for companies that have the balance sheets to fund corporate activity, liability management could be another source of new corporate issuance. Martin Wiwen-Nilsson, a partner at Goldman Sachs, says that Russian companies in particular have been eager to capitalize on strong investor demand to smooth out the maturity profile of their debt at little or no new issue premium.
An $850 million, seven-year issue by steel company Evraz, led by Goldman Sachs alongside ING and VTB, replaced more than half of the borrower’s outstanding 2103, 8.75% bonds. “Evraz was a good example of a company very successfully issuing and simultaneously buying back bonds, and we expect to see more transactions of this kind out of EM this year,” says Wiwen-Nilsson.
FOCUS ON INFRASTRUCTURE
Infrastructure spending remains a big hope for future issuance in the region’s corporate bond markets. The World Bank recently estimated that Russia’s energy inefficiency equals the annual energy consumption of France. “Achieving Russia’s full energy efficiency potential would cost a total of $320 billion to the economy and result in annual cost savings to investors and end-users of about $80 billion, paying back in just four years.”
Bankers say over the short term, the principal source of infrastructure-related issuance in Russia will come from state-owned bank Vnesheconombank. “Vnesheconombank has a larger funding requirement than any other CEE borrower in 2011,” says Raiffeisen’s Shpilevoy. The bank has already announced capital-raising plans for up to $8 billion in bonds and loans this year to fund infrastructure projects, “but not in the form of classic infrastructure bonds”.
But bankers caution that investment in infrastructure has often failed to live up to expectations. “Just looking at the CEE region, the EIB has forecast that infrastructure financing needs over the coming years will exceed E500 billion,” says Philipp Reimnitz, co-head of project and commodity finance at UniCredit.
“Project financing in the region reached about E15 billion in 2010, so there is clearly a big pipeline of projects to be financed. But not as much is coming to fruition as we had hoped.”
Even for projects that are given the green light, how much of the financing is likely to make its way into the bond market and be made accessible to international investors is unclear. Reimnitz says that initiatives such as the credit enhancement offered by the EIB for up to 20% of the senior debt for the Trans-European Network (TEN) may act as a spur for attracting bond funding for CEE infrastructure projects.
More broadly, Reimnitz is doubtful that bond investors will be drawn to big-ticket infrastructure financings as long as there are concerns over regulatory risk, as well as potential currency and traffic risk.