The current market turmoil will not spark a buying spree for EM corporate debt in the first half of this year, as investors fear a further deterioration in Western credit cycles.
This is the consensus view among EM asset managers and analysts expressed at this week’s Emerging Markets Traders Association (EMTA) corporate bond forum.
“Liquidity is tight and some returns are very negative so we now have to move to defensive sectors such as utilities and telecoms,” said Polina Kurdyavko, portfolio manager at BlueBay Asset Management.
Investors are now more bearish toward the asset class despite their belief in its strong, long-term fundamentals. They believe that premiums are high from a relative value perspective and the market has yet to price this in - along with increasing derivative risks, the rising pressures on bank balance sheets and possible asset firesales.
“The volatility of EM equities last week showed these markets could not be decoupled. So although I think some valuations in the high yield market is reasonably constructive, investors don’t feel in practice the concessions are anywhere near close to competitive,” said Victoria Miles, co-head of EM corporate research at JP Morgan.
Market participants predict EM spreads on investment and sub-investment bonds will drag wider with corporate defaults spiking up at the end of the year and fund managers building up cash, leaving a diminishing supply of new issuance.
Retreating investors
In this environment of market distress, crossover investors are now in retreat – a significant blow to the 5-year trend whereby EM corporate issuers have successfully attracted a broad investor base.
“The marginal buyer has disappeared and they are not coming back. This is because of the extra focus on balance sheets and the fact that repo rates as well as haircut rates have gone up. This means some hedge funds have not been able to get financing at all,” said Eric Jayaweera, who runs the EEMEA credit trading business at UBS.
This year, investors will bank on safe, liquid and higher rated bonds with short tenors that have been affected by the sell-off and now offer large carry. This would reduce the potential widening of spreads in the near-term, according to Jayaweera.
Kurdyavko suggested that Western asset managers might now delay plans to increase their portfolio allocation of local currency corporate paper this year due to global economy fears as well as the stubborn price sensitivity of EM corporates and lack of secondary market liquidity.
“This is not the year for the local currency market. It is made up almost entirely of sovereign paper and investors are not currently adequately compensated for the loss of liquidity that you are getting in the corporate space and the expensive prices against the sovereign,” she explained.
But Tomasz Stadnik, emerging markets portfolio manager at ABN AMRO Asset Management - who requested an increase in the maximum permitted allocation in local currency investment from 15% to 50% when he joined the fund mid-2007 - is still bullish.
“We are looking beyond hard currency in many cases...because spreads are still not wide enough to be appealing in many cases - there are more appealing opportunities in local markets,” he tells Emerging Markets.
He talked up the long-term opportunities in the local markets in China, India, Russia and Ukraine. “These individual currencies are still undervalued, especially where central banks are likely to need appreciation to fight inflation.”
ING estimates there will be $106 billion worth of EM corporate issuance this year, half of which comprises of deals postponed last year – but this is still a 31% year-on-year decline.
Around $30 billion of Eurobonds will come out of the CIS in 2008 – dominated by the well-known high-graders such as Russia’s VTB, Russian Agricultural Bank and TransCreditBank as well as Kazakh borrowers such as the Development Bank of Kazakhstan.
Doubts remain
But doubts were raised over the sustainability of the tight spreads over the sovereign of bonds from state-owned and private Russian banks with Miles suggesting the external vulnerability of the sector means it could not decouple from the volatile trading performance of Western financials.
“I am concerned that external borrowing of Russian banks amounts to 25% of their liabilities – this means they are vulnerable.”
Furthermore, Miles predicted that there would be no easy recovery for Kazakh assets with the current implied default probability on most of the Kazakh bank CDS widening even further over the last few weeks.
“The dependency on external markets is very high for borrowers in the region and I am very worried about their technical positions in Kazakhstan. I feel the pain has yet to play out for financials – they are reporting stellar results even as the economy increasingly looks like it is grinding to a halt,” she argued.
This negative sentiment for CIS high-graders – let alone junk high-yielders in the region - contrasted sharply the appetite for Middle Eastern and African borrowers with investors attracted by the region’s low correlation to developed market business cycles.
There was some enthusiasm for the projected $16 billion of Asian issuance from the first half of the year, much of this from Indian and Korean banks, due to their strong growth prospects and relatively low leverage.
However, investors admit their portfolio decisions are ultimately beholden to top-down calls about the global economy as well as the extent of corporate default rates globally and its impact on pricing and risk appetite later in the year.
Consequently, corporate borrowers are now seeking alternative and more stable sources of funding.
“We are now seeing an increase in private placements. These have no mark to market difficulties and information is still high compared to Eurobond issues,” revealed Jayaweera.
Miles noted that issuers, such as blue-chip state-owned Russian companies, might seek to access the syndicated loan market as a bulwark against the volatility of external markets this year.
Upward trend
But it is not yet clear if this will prove to be an upward trend this year - if balance sheet worries continue to blight US and European banks, financial institutions may snub rolling over maturing syndicated loans - spurring borrowers to access capital markets.
Nevertheless, this tightening of liquidity ultimately prove to be a well-needed correction, serving “for the first time to differentiate credits and increase our understanding of the fundamentals of defensive sectors - allowing us to make money on a relative value opportunity,” said Kurdyavko.
She also argued that the impact of the credit crunch was not just on pricing and risk premiums since it would galvanize demands for improved risk management for EM corporates. This contrasts the laxity over the last few years whereby accounts were given some leeway to “window dress”.
“Investors are now more worried about bad corporate governance and lack of disclosure in this environment. So a key risk is financial mismanagement since a lot of issuers this year are living in an era of aggressive growth and high expansion strategy without taking into account the current market conditions,” she concluded.