In January the Republic of Argentina launched a $2 billion 20-year global bond. It was almost four times oversubscribed, priced below the indicated spread range and still tightened 40 basis points in the first two days’ trading. The Argentina/Mexico spread differential at 20 years fell from 120bp to 75bp.
As the issue was launched, bookrunner Merrill Lynch’s head of fixed income Jim Quigley enthused: “We saw accounts in this that we have never seen in an emerging market instrument before. There were high-quality European pension funds, sophisticated financial institutions which usually buy only triple-A and double-A securities.” Other syndicate members confirm that many accounts who normally balk at paper over seven years piled enthusiastically into the issue.
They needn’t have panicked. There is plenty more high-yield sovereign paper coming to market. Uzbekistan plans a debut Eurobond; Brazil is to launch its longest-dated deal yet at 20 years; Lebanese issuers are queuing up and entitities from Croatia, Lithuania and Romania ;even Polish municipalities are keen to sup at the trough of global liquidity.
This may be great news for underwriters, but it’s bad news for the market. When neophyte buyers dip their toes in the 20-year end of the Argentine curve it is clear that a bubble is not only forming, it’s close to bursting. As Jan Loeys, fixed-income researcher at JP Morgan in London puts it: “The rapid pace of appreciation of the riskier markets and the widening of the investor base are increasing the likelihood that a new asset price bubble is being inflated in global markets. The longer global funding costs are kept at historically low levels the greater will be the temptation to trust in the “greater fool” who will push yields down even further.”
These “fools” have driven the emerging market bond index spreads to US treasuries down from 1000bp to 450bp; they have caused the collapse in spreads between European high-yielders and their core benchmarks and between other developed market high-yield debt such as Canada and Australia and their benchmark, the US; and they have forced corporate spreads to levels at which they hardly offer a sufficient premium for default risk.
“Spreads are akin to distantly out-of-the-money options written by bond holders,” explains Mark Capleton, international bond strategist at BZW. “With spreads so tight investors accept extremely adverse negative convexity with respect to creditworthiness. The long-term cumulative default statistics from the ratings agencies suggest spreads are still slightly more than adequate … but there’s also the question of payment for liquidity sacrifice compared to governments.”
Capleton believes that many of the ingredients of a bubble are present: investors are accepting a longer-term risk for a given credit to achieve a target yield/spread; they are accepting greater credit risk to achieve a target yield/spread; they are accepting less stringent covenants for a given issuer, term and yield and they are accepting more optionality against them (call/put features) for a given issuer, term and yield. One of these trends would be worrying; their coexistence looks like a leading indicator for a meltdown.
As in previous bubbles there are two explanations for what is happening. People who make money from selling securities argue that investors have simply become more sophisticated with regard to credit and have fundamentally reappraised their views on corporate and emerging market debt. Proponents of the bubble theory believe that excessive liquidity has created a wall of money as it did, for example, in the Japanese equity market in the late 1980s and the Nikkei is still sub-20,000.
The fundamentalists argue that increasing investor familiarity with relative value analysis has led to a new willingness to take credit risk for enhanced yield. “Investors now are much more aware of credit risk on its own,” says one head of fixed income.”They are also much more aware of the potential for risk reduction through diversification people are looking at, say, France versus Argentina and seeing that there is not much correlation. Buying this kind of paper reduces risk for people who have previously only invested in high-quality debt from a small group of correlated issuers.”
This does not explain at all the market’s insatiable urge to double its bets. Buyers of 20-year paper from Brazil, a 30-year global from Colombia and a 100-year deal from Chilean corporate Endesa are not sober quants looking at efficient frontiers they are yield hogs gambling at maturities which dramatically increase duration and credit risk.
The banks also argue that the possibility of a single European currency has forced European investors into credit analysis whether they see the benefits or not. “If there is one currency in Europe then investors will have to differentiate between markets on the basis of credit [as the governments in Emu will lose the right to print money],” says another bond salesman. “Also, they will have to look elsewhere for currency diversification and that will mean markets that they have previously thought of as exotic.”
Banks that sell European bonds and trade European currencies face an uncertain and potentially much less profitable future in a post-Emu market. If they are to continue to carry the overheads and expensive infrastructure of multi-currency securities trading it is they not investors who have no choice but to move into new markets. This, rather than a fundamental shift in investors’ perceptions of credit spreads, may explain the sudden surge in origination trips booked to exotic issuers, in glowing evaluations of basket-case countries and in the touting of often exotic derivatives on emerging market currencies and debt instruments.
As a fallback, many bond houses say that any focus on the level of spread compression is to miss the point completely: we should no longer characterize many of these markets as “emerging”, they have now emerged and that is why spreads have come down. They have fallen so fast, it is claimed, because cautious investors wait until the fundamentals have settled down before they are willing to buy in. Emerged is an interesting definition of countries such as Colombia, Panama and the Lebanon and one that takes little notice of the proximity of the last crisis in Mexico. Default and exchange rate risks in most Latin American, east European and smaller Asian markets are still very high. These are still emerging markets and they will remain so for years.
Against the fundamentalists are those who say that a global liquidity glut has created an asset price bubble that will burst when the sources of that liquidity dry up. With yen interest rates close to zero Japanese investors have rushed abroad in search of yield. Opportunistic foreign investors have used low yen funding costs to play spread games on their own creditworthiness: borrow and invest in lower-rated credits or risky derivatives trades for an immediate yield pick-up.
The existence of this weight of hot money is worrying enough, as hot money cools more quickly than markets or risk management teams can react.
The truth is as simple as it is unpalatable. In the race for performance, investors have lost sight of the risk/reward ratio as they did three years ago. The rush to jump on the spread bandwagon has overtaken any sensible relative-value judgements and the better these emerging markets perform the more investors who have never invested in such securities before have to buy them to match the performance of peers who have beaten them to it. The later an institution joins this race, the more risk it must take to make up for lost performance.
And who are these investors? The clues are in the underwriters’ defences of their new issues. They talk of backstop bids in the asset swap market, credit arbitrage and investors looking for Libor-plus returns. That means the biggest and least discerning floating-rate asset chasers of all: overcapitalized banks. Their ability to delude themselves over credit risk is second to none.
Asked what trends the next 12 months will bring heads of bond syndication and of medium-term note sales all agree: more emerging market debt, more subordinated debt and a further plunge down the credit spectrum to sub-single-A corporate paper. Good news for issuers and underwriters.
But buyers should remember that junk is junk and when no-one wants to buy it, there is no backstop bid in the asset swap market or anywhere else.
Mark Parsley
