What next for emerging markets? At the beginning of March, strong liquidity and a good external environment offered emerging markets borrowers the perfect opportunity to raise funds. But recent concerns about US interest rates and inflation, together with a reduced global risk appetite mean that fundraising is becoming a trickier proposition for many credits.
The consensus is that the outlook for emerging markets remains good. "Medium-term technicals remain highly supportive, and when global markets stabilize, emerging debt is expected to rally back rapidly," says Jerome Booth, head of research at Ashmore Investment Management.
Booth is confident that excess global liquidity will continue to make its way towards emerging markets in due course. "The market, which under-performed high yield last year, remains cheap to other credit markets and a much stronger diversifier," he adds.
One bad sign, however, was that the 253 funds tracked by Emerging Portfolio Fund Research (EPFR), a US data outfit, saw their first weekly outflow in 21 weeks at the end of March. Investors exited following ambiguous comments from the US Federal Reserve. This represented a dramatic turnaround in investor sentiment. A few weeks earlier, the week ending March 9 in fact, these funds saw a record-breaking $500 million of inflows.
The difference, though, between today's volatile environment and previous interest rate tightening cycles is that the fundamentals in emerging markets are good. Investors are still keen and once the market stabilizes, bankers are confident that issuers will return. "This is a yield product and many investors want to buy it," says Michael Schoen, head of Latin American debt capital markets at CSFB. "The asset class has been firing on all cylinders."
Up until the beginning of March, almost any emerging market borrower could launch a bond, according to Schoen. "Recently the market has proven very receptive to virtually all types of issuers," he says.
In February, deals out of Latin America from both ends of the credit spectrum demonstrated just how keen investors, ranging from dedicated emerging markets funds to US high-yield and high-grade accounts to hedge funds, were to get their hands on emerging markets debt.
In the middle of the month, a $1 billion, 30-year bond by Mexican telecom firm America Movil, which is rated investment grade by the ratings agencies, proved so attractive that it caused a rally in the spreads of Mexican sovereign bonds during its marketing phase.
Doubling up
The transaction, which was lead managed by CSFB, attracted almost $3 billion of orders from more than 110 investors, 80% of which were high-grade accounts, mostly in the US. The final amount raised was double the initial projection. US investors were particularly keen to gain access to a top-rated long-dated bond.
Two weeks later, lowly-rated Venezuela issued a very successful E1 billion, 10-year bond. The world's fifth biggest oil exporter doubled the transaction as investors snapped up its first euro-denominated bond in four years. The order book reached E4 billion, with most of the demand coming from the UK, Switzerland, Germany and the US.
Investors in these countries bought 65% of the deal, with the rest going to accounts in Latin America, Asia and other European countries. Investors saw the trade as an opportunity to take advantage of the high oil price, even though Moody's rates the sovereign B2 and Standard & Poor's B.
Venezuela's deal was well timed. It's unlikely the sovereign would be able to issue now. For some investors the correction – if that is what the sell-off proves to be – couldn't have come soon enough. Some fund managers had become concerned that emerging market debt had looked like a bubble, with the spread over US Treasuries in early March at 330bp.
That was the lowest level since 1997 and compares to an average of 732bp since 1998. "It's a little bit mystifying how content the market seems to be," said Mark Siegel, portfolio manager at DL Babson, at the time. "I wouldn't be surprised, if we look back in 12 months' time and think it was reasonable to suspect that we were set up for a crisis."
The spread over US treasuries now is closer to 400bp, though some investors, such as Booth, see the situation as a buying opportunity. Susanne Gahler, director of the emerging debt group at F&C Asset Management, adds that Latin America's bonds are probably the most attractive within the emerging markets in terms of valuations. "From a global [emerging markets] fund manager's perspective, Latin American spreads are still the highest," she says.
It's the external environment, she adds, that is key to how Latin American debt fares over the coming months. If US interest rate hikes are managed gradually, then the market is unlikely to be too concerned over the long term. But if the Fed is forced into stronger action then the present sell-off might become more entrenched. As Cameron Brandt, senior global markets analyst at EPFR, says emerging markets remain "vulnerable to shifting expectations about the pace of US interest rates as, to a lesser degree, do European and developed Asian credits."
The message from the Federal Reserve is ambiguous – something the market hates. In March, as expected, the central bank raised interest rates by 25bp, maintained a "measured" rhetoric, but also intimated a more hawkish approach going forward amid concerns over pricing power.
"The Fed's task of slightly reducing the accommodative monetary policy yet coping with short-term supply shocks [from oil] and the expected, but probably limited, import price impact of devaluation is causing market confusion and, for now, reduction of risk appetite," says Booth.
Choppier
This year's sell-off is different from the one last April and May, adds Booth. Then the market was closed to all borrowers; certainly today the situation is not as extreme. One big difference between now and last May, according to Walter Molano, managing partner at BCP Securities, is the direction of commodity prices.
Then fears of a hard landing in China sent commodity prices lower. But now that China's economic outlook appears to be brighter, commodity prices are once again rising, which is great news for many developing countries that are so reliant on income earned from oil and mineral exports.
"The double combination of lower commodity prices and a weaker Treasury market were the main reasons why the emerging markets imploded in May last year. [But] the picture is very different now," says Molano.
Some investors still think, however, that the present situation could get much worse. "If you observe a market that seems to be all one way, with valuations over-optimistic relative to fundamentals, then systematically it's more vulnerable," says Siegel.
One more note of caution comes from EPFR. The latest shift in US monetary policy has hit high-yield funds hard. They posted net outflows for the ninth time in the past 11 weeks at the end of March and suffered a -0.8% return drop in the value of their collective portfolios. And as bond market experts point out, the high-yield market is a good barometer of what will happen in the emerging markets.
Diversity is the spice of life
Market volatility may have postponed Latin issuance for the time being,
but when conditions improve, the region's borrowers should find a receptive audience.
For the first time since the turn of the century, issuers in the region can tap every investor group in the world, with the possible exception of Japanese funds, who are still smarting from the Argentine debt default.
In the past six months alone, Latin sovereigns and corporates have issued: dollar-denominated bonds; local-currency global bonds; vanilla local-currency bonds; euro-denominated bonds; and dollar-denominated perpetual bonds.
Ground-breaking
These bonds have targeted all types of investors from US high-grade and high-yield institutional funds to Asian retail accounts. Many are also genuinely ground-breaking transactions, either highlighting innovative structures or setting new records for maturity, size and pricing.
Perhaps the most ambitious transaction was Pemex's $1.75 billion perpetual non-call five-year deal (see page 22 for more details). This transaction, together with a similar one by Mexican tortilla group Gruma, opened the one investor base that had ignored Latin America in the past, namely Asia.
Now the region's borrowers know they can raise money from US, European and Asian (excluding Japan) investors. "Having such liquidity across the globe is a very significant evolution for our market," says Dan Vallimarescu, head of Latin American debt capital markets at Merrill Lynch.
Another big theme to emerge over the past few months is the euro's renaissance as a fund raising currency. "After the Argentina financial crisis, the euro-denominated market effectively closed, but now it's re-opened, which is a plus," says Susanne Gahler, director of the emerging debt group at F&C Asset Management.
With US rates on an upward trend, many Latin borrowers are beginning to see the euro market as a safer option. It also makes sense for these credits to diversify their investor base and avoid saturating the dollar market. Notable transactions so far this year include Brazil's first deal of 2005 – although that was after it was unable to rouse sufficient interest in the dollar market. Venezuela also recently executed a much sought after euro transaction – its first in that market for four years.
Local-currency bonds
Another option available to borrowers is local-currency bonds either distributed domestically or to international investors through a Eurobond structure. Uruguay, Colombia and Brazilian banks ABN Amro Real and Votorantim have all issued bonds using the latter structure. Gahler reckons the big interest shown by investors in local currency debt to be "the most dramatic development" in Latin America.
She says it's a result of two things: a weaker dollar and investors searching for yield. "Mainstream investors are following hedge funds into currency plays." Gahler, however, is unsure whether the growing interest in local currency markets by investors is a short-term fad or something more substantial.
"Some people feel, and they could be right, it's the beginning of something new – a new market that could mature," she says. "We will have to see how the year progresses."
Corporate comeback
One striking feature of the Latin capital markets is the re-emergence of the non-sovereign borrower. The region's banks and corporates are looking to raise money, which is good news for yield-hungry investors.
Non-sovereigns (including state-owned companies) had placed $5.3 billion of bonds in the international capital markets by the end of March. Admittedly this volume is largely a result of three big deals by high-grade corporates – Pemex, which launched a record-breaking E1 billion, 20-year transaction; America Movil, which issued a $1 billion, 30-year deal; and Telmex, which raised $1.75 billion through a five- and 10-year dual tranche bond.
The latter was originally issued at the end of January and raised $1.3 billion in total. Both notes, however, were subsequently re-opened in March after the lead managers received a number of enquiries from investors, who were desperate to buy some of the debt. The strength of demand forced Telmex back into the dollar market, even though initially the wireline firm wanted to try other debt markets.
But while corporates such as Pemex and Telmex are well-known borrowers, even lower-rated, less regular corporate issuers are taking advantage of the strong liquid conditions to fund themselves. Atiq Rehman, head of global emerging markets at Citigroup, reckons high-yield corporate issuance will be one of the big themes this year. Michael Schoen, head of Latin American debt capital markets at CSFB, agrees: "I think if anything, the market is more receptive to high-yield Latin American corporate names than we've seen in the past."
So far, only a few high-yield borrowers have placed bonds in the international markets, including Argentine beer company Quilmes, which launched a $150 million, seven-year bond that investors lapped up as it was a rare opportunity for them to play the country's growth story. But investment bankers expect the pace to pick up once companies have finalized their year-end numbers and market conditions improve. A number of Brazilian and Mexican corporates are hoping to tap the markets in the second quarter.
Banks are also raising capital. First Caribbean Bank, which is owned by Barclays and CIBC, tapped the dollar market for $200 million of lower tier-two capital. The deal, which was lead managed by the bank's owners, received strong demand, allowing First Caribbean to achieve tight pricing. Brazil's banks have also been active, with Banco ABN Amro Real and Votorantim both following Colombia's lead by issuing local-currency-denominated global bonds. Votorantim is also seeking to raise money in the dollar market.