EM DEBT: Staying alive

For a while, it seemed the party would never end. In just five years following the collapse of Lehman Brothers, the total volume of outstanding debt issued by emerging market sovereigns and corporates expanded four-fold, to more than $1 trillion.

It seemed the perfect asset class, offering yield (in short supply in depressed western markets) due to the higher risk, but backed by soaring economic growth. Debt sales by all emerging corporates hit $462 billion in 2012, up 50% year-on-year, with sovereign issuance rising 42% over the same period to $110 billion. When 2013 started with a bang, with $267 billion in cross-border capital flowing into emerging markets in the first quarter, according to data from the Bank for International Settlements, many predicted another stellar year.

But things abruptly changed. On May 22, Federal Reserve chief Ben Bernanke heralded the beginning of the end of quantitative easing (QE), and the return of higher US Treasury yields and tighter western monetary policy. That process will likely take years. Despite market expectations that cutting down on liquidity provision will happen in the first month of autumn, Bernanke took a shock decision on September 18 to delay the onset of tapering for several months. Yet the Fed’s May meeting was enough to convince many investors to flip capital back into developed markets.

Emerging market outflows rose through the summer. India was hit particularly hard, with $5.7 billion in global funds fleeing the country in June alone, beating the previous record set in October 2008. India and Turkey, energy-poor nations with high structural deficits, saw their currencies slump against the dollar. By end-August, year-to-date emerging markets capital flows had turned negative, totaling -$11 billion, according to data provider EPFR.

Suddenly, the future for emerging market debt looked bleak. For years, notes Benoit Anne, head of emerging market strategy at Société Générale, global capital had “just rushed headlong into emerging markets, chasing yield. Suddenly, it looked like more yield was available elsewhere, and in much less risky markets. So the capital rushed out again.”

Yet as the summer lengthened, it became clear that investors hadn’t given up entirely on the asset class. True, emerging markets struggled to stem fund outflows over the summer. But individual sales, even in riskier frontier states, continued to pepper the market, even at inopportune moments.

Nigeria opted to plough ahead with a $1 billion sale of 10-year Eurobonds, priced to yield a generous 6.375%, in the turbulent days following the Fed’s May meeting. South Africa sold $2 billion-worth of 12-year bonds in the stormy week leading up to the Fed’s September surprise. The US central bank’s decision to delay tapering made the sale by Johannesburg look both brave and wise.

Latin America corporate bond issuance in the current year to September 15, meanwhile, is at a record high, at $68 billion, up 5% year-on-year on 2012 figures, and up 30% on 2011 figures.

GROWN UP

Many see this as a sign that emerging market debt as an asset class has finally come of age. Despite recent events, it remains “very much alive”, notes Lorenz Altenburg, head of corporate and emerging market syndicate, EMEA, at Nomura. “We just happened to hit a bump in the road for a few months.”

Some emerging markets, to be sure, are struggling to implement the sort of scrutable reforms that investors crave. China and Brazil remain in thrall to the public sector; India’s fiscal and current account deficits are exacerbated by a slowing economy; political and industrial unrest plague Turkey and South Africa. Yet the sense remains that marginal investors enjoyed the opportunity over the summer to weigh up the pros and cons of emerging market debt. “It gave investors the opportunity, if they needed it, to sit on the sidelines, digest the record supply of the first few months of the year and wait for events to play out,” notes Paul Tregidgo, vice-chairman of DCM at Credit Suisse.

Those events are still very much in flux, even as autumn rolls past. The Fed’s September meeting appeared marginally to benefit emerging debt securities. In the week ending September 18, just $288 million exited emerging market-dedicated bond funds, the slowest outflow in 17 weeks, and significantly down on the previous week’s net outflow of $1.1 billion.

The Fed’s decision, notes SocGen’s Anne, “allowed emerging markets to recover, and regain some of their lost momentum.”

This provided “clear short-term relief” to emerging markets, UniCredit, whose analysts had compiled the data, wrote in a September 20 note. It also reinforced the notion that emerging market sentiment remains entangled with US monetary policy, rather than being a self-propelled asset class, moulded and shaped by central banks from Jakarta to Johannesburg.

For proof of this, look to the clear correlation between US Treasury yields and emerging market bond outflows, which persisted long after summer was gone. When Treasury yields rise, as they did in August and early September, funds bolt emerging debt; when yields fall, as they did in the week ending September 18, when they slipped 22 basis points to 2.69%, funds either return, or temper the speed of their departure.

All eyes are now on sovereigns and corporates, keen to tap international debt markets for capital. Bankers interviewed for this story are naturally keen to talk up potential sales: “I’ve got five corporates [lined up to issue bonds] in Turkey alone,” says one London-based debt banker. Adds Nomura’s Altenburg: “We expect to see some corporate issuance in the Middle East, notably in the UAE, as the market recovers.”

SocGen’s Anne sees deal flow rising through the final quarter in the countries hit hardest by the summer slump, notably Turkey and Russia.

Others point to Latin America as a likely source of new paper. Across the region, bond markets have remained robust on both the corporate and sovereign side. In the current year to September 15, Latin American firms raised $68 billion in fresh corporate debt, against $63 billion during the same period a year ago, while sovereign sales rose slightly over the same period, to $13.6 billion. In mid-August, Bolivia squeezed through a 10-year bond, printing $500 million in new paper in a trying market.

“If a relatively new participant such as Bolivia was able to come back to the table so positively and successfully, that bodes well for the broader market,” says Credit Suisse’s Tregidgo.

HIGH RISK, HIGH REWARD

Then there’s sub-Saharan Africa, a region where risk and reward remain higher than virtually any other emerging region. Yet even here, says Credit Suisse’s Tregidgo, investors “have been attracted to countries that can demonstrate the capacity and potential for progress and development within the framework of the global economy.”

Clear-cut examples include Rwanda, which launched its debut sovereign bond in April, raising $400 million, and Kenya, buoyant and revived following peaceful presidential elections in March. The Fed’s September surprise may now convince authorities in Nairobi to enlarge a planned bond sale to $1.5 billion from $1 billion, and bring it forward to October, from December. Tanzania is also hoping to finalize a tricky $1 billion sovereign before the year is out, while Senegal and Angola have also announced plans to test fund appetite for frontier debt.

Opportunities also exist on the margins, in half-forgotten jurisdictions like central and eastern Europe (CEE). In its September 20 note, UniCredit pointed to opportunities across the region, with Croatia, Hungary and Ukraine, all keen to finance 2014 debt repayments, seen heading a list of potential sovereign issuers. The entire CEE region has been a relative oasis of calm during the summer, avoiding the currency collapses and stock slumps seen elsewhere.

Some areas are struggling to regain momentum, notably Asia, which benefitted more than most from the West’s economic slump. Emerging investors love the region for its broad political stability and fiscal probity. Yet debt sales have struggled this year. Sovereigns in south-east Asia raised $7.3 billion from the bond markets in the current year to September 15, two-thirds of the total raised in the same period a year ago. Corporate issuance in the region is down 40% over the same period, with Indonesia, widely expected to be a major player in corporate debt space this year, proving a notable disappointment.

LOANS

Many Asian corporates have turned to the loan market for help instead, finding succour in a market that, says Philip Lipton, Asia-Pacific head of syndicated finance at HSBC, has remained “very liquid” across most of Asia, with pricing falling even on large syndicated deals. In September, India’s Reliance Industries issued a $1.75 billion syndicated loan, receiving better pricing than it did on a large loan 12 months before. The previous month, leading Chinese telecoms equipment maker Huawei raised $1.5 billion in fresh funding, split between a five-year loan and a revolving credit facility.

Much of the activity in east Asia stems from capital-hungry Chinese energy and property firms. Hong Kong-listed Hilong Holding launched a $200 million loan in August; Shimao Property, Hopson Development and Agile Property have also opted for loans over bonds, with much of the liquidity sourced from banks in Korea and Taiwan. In China, a new asset class, Entrusted Lending, is even helping corporates bypass banks and channel cash straight to one another.

A few emerging market issuers have even chosen an unusual way to tap international bond markets: by printing new paper in euros rather than dollars. There are good reasons for this switch. Issuers can diversify their investment base, while saving a bit of money: through late summer and into the autumn, euros remained a marginally cheaper funding option than the greenback.

Euro-denominated sales have proven popular across the emerging world, with issuance emanating from such diverse institutions as Korea Development Bank, the Russian Federation, America Movil, Gazprom and Banco do Brasil. Russia’s single euro-denominated tranche in a complex, $7 billion September bond sale was increased at the last minute, to 750 million euros ($1 billion).

So we enter autumn with emerging market debt in an unexpectedly bullish mood. Some regions are struggling for traction, but this is, broadly speaking, a market that has emerged from a tough summer in surprisingly good health. Issuance is on the rise again, with sluggish markets exploring new funding options, proving once again that necessity is the mother of invention.

Over the summer, notes SocGen’s Anne, “we were in panic mode, with investors rushing for the exit.” That, he says, has now changed. “Growth in emerging markets is starting to pick up again. The panic is over. We are now looking at fundamentals and country-specific stories, evaluating them on a case-by-case basis, rather than being mere Fed-watchers.”

“Chatter about an emerging market debt 'party' misses the point,” notes Credit Suisse’s Tregidgo, who believes asset classes are built on “solid, long-term assessment of market fundamentals” rather than the capricious nature of short-term investment flows. “On that basis,” he adds, “there is every reason to expect emerging market debt to develop increasing significance for issuers and investors alike.”