Investors are well and truly spooked by the current financial crisis. Their nervousness, together with Asian inexperience in dealing with meltdowns, led to last month’s pulling of a $2 billion bond for Korea Development Bank. During an investors’ conference call on December 11, one fund manager asked for a breakdown in the maturity of Korea’s short-term debt falling due: what was the mix between one-month, three-month, six-month and 12-month liabilities?
But the two senior Koreans – one from the finance ministry, the other from the Korea Development Bank – answering questions were unable to provide a coherent reply. In desperation one suggested the caller divide the total short-term liabilities by 12 to get a monthly figure. The naivety of the response raised both gasps of horror and laughter among the other fund managers listening in.
Later that day JP Morgan, lead manager for the planned three-year issue, bowed to the inevitable and announced its postponement until sometime this year. Earlier when sounding out investors, JP Morgan had hoped the deal might be completed at a spread of between 350 basis points and 400bp over US treasuries. That would have been quite a step up for a borrower whose bonds had traded at around 80bp over in the first half of last year and which, even in October, could have borrowed at 150bp over.
Little appetite
Even at such wide levels, there was little appetite for buying new Korean debt. Almost immediately, investors talked the spread up to 425bp. As more bad news emerged about Korea’s short-term debt levels and forex reserves, and as the country appeared to backslide on implementing its IMF agreements, investors grew increasingly worried.
One British fund manager listening to the fateful conference call picked up very different signals from his peers as they quizzed the Koreans. Far from considering giving the Koreans any more money, he sensed that investors were trying to get information with a view to selling their existing holdings. “I remember hearing the desperation in some questioners’ voices and thinking to myself, ‘yes, these guys own a lot’.”
The real nightmare for investors is that recent downgrades, taking Indonesian, Thai and Korean debt to junk bond status may unleash a wave of selling. The prospect of a moratorium being called is also in investors’ minds. Even their best-case outlook is for continued volatility combined with new supply as emerging market borrowers desperately try to raise money.
But to tough fund managers, unbound by strict investment rules, the current malaise is the ideal buying opportunity. “We have seen spreads on countries such as Argentina and Venezuela go to 700bp to 800bp over US treasuries when fundamental fair value is at half that level,” says Paul Ghaffari, managing director at Morgan Stanley Asset Management. “If we see more sell-offs like that this year, we will be investing, because it’s a great opportunity to put new clients’ money into the markets.”
Other optimistic investors admit they are fully invested so their comments may be designed to talk the market up. “I’m bullish. But I was bullish when the markets were 10 points higher,” says Tom Cooper, a fund manager at Grantham Mayo Van Otterloo. “We remain fully invested because we don’t believe our clients give us their money for us to put it into cash. I do think there are bargains out there, but it doesn’t really matter to us. We have a very low turnover approach.”
A contrarian approach to investing needs a theory to support it and theories are being constructed to bolster the quick recovery argument. Plenty of sell-side analysts are eager to point out that the bonds of many emerging market issuers were over-sold last year, and that spreads now are far too wide for the strong credit fundamentals of many emerging-market countries, especially in Latin America and eastern Europe.
Desmond Lachman, head of emerging-markets economic research at Salomon Smith Barney, is one who draws a distinction between recent events in Asia and those in late 1994 and 1995, following the Mexican peso crisis. Then, he argues, emerging markets sold off because of a real deterioration in the credit fundamentals of large Latin American countries and a real increased likelihood of default. The recent Asian sell off, he suggests, springs much more from forced selling by margin buyers of emerging market debt which had rallied to unsustainable levels in late 1996 and early 1997.
The crisis has persisted because other buyers such as bank trading desks and hedge funds which would normally have picked up this paper stayed on the sidelines late last year. They did not want to take any hits in a period of short-term volatility and have to record mark-to-market losses before year-end. The bull case is that, unlike in 1995, “we are not talking about potential defaults here,” says Lachman. “The Latin Americans have better fundamentals than in 1995. Asian debt looks particularly cheap in relation to credit fundamentals, though in the near term we would be cautious.” But he insists: “The sell-off has been as divorced from fundamentals as was the run-up. We may see an even quicker recovery than in 1995. We are optimistic for 1998. There is good value out there, particularly on the local currency side.”
Clever selection
One aspect of the present panic is certainly familiar to veterans of earlier crises including the Mexican peso devaluation of 1994 and 1995. In such extreme conditions, the emerging debt markets become highly correlated. “In general, the market is cheap,” says David Reiss, managing director at Bankers Trust Investment Management. Following this theory, for any investor convinced of a recovery in emerging markets next year, it almost doesn’t matter where you put your money as long as you do invest it. “Usually, if markets do recover, the higher-yielding names have the stronger recovery,” says Reiss.
But the highest returns will come from clever selection. As soon as some stability returns and buyers distinguish between different regions and countries, the obvious bargains will indeed look compelling.
Certainly, recent shocks in Asia serve to emphasize the strong fundamentals of a country such as Argentina. The economy is in better shape than in 1995 with higher growth and lower inflation. Though standard credit measures such as external debt as a proportion of GDP at 34%, external debt as a proportion of exports at 370% and debt service ratios, all look similar now to 1995, the country is much better positioned than in 1995 to withstand the emerging-market downturn. Argentina’s forex reserves are enough to cover seven months of imports and it has sources of committed medium- and long-term funding from commercial banks and the IMF. The country is getting on with privatization. Spreads on longer duration Argentine dollar bonds were already narrowing from highs of around 800bp to below 600bp in December.
Most of all, investors are looking for countries where political leaders appear capable of sound economic management, providing strong responses to crises and delivering a clear message on their own currencies. Russian assets rallied in December when interest rates rose sharply. Even Brazil, the Latin American country most affected by the Asian crisis, won some credit for its quick response to depletion of currency reserves last October. “They did the right things and did them fast,” says Helene Williamson, director of fixed-income investment at Foreign & Colonial Emerging Markets.
First Brazil raised interest rates from 21% to 43% to demonstrate commitment to the exchange rate of the real, then in November passed a package of measures designed to improve the fiscal accounts. Brazil may suffer for its high level of domestic debt, and high interest rates designed to bolster the currency and fight inflation will hurt economic growth. But for all that its leaders look impressive compared with Asian peers.
“It shows that the Latin Americans have grown used to market discipline,” says Williamson, “whereas the signal the Koreans sent by pulling the $2 billion KDB deal was of an inability to accept what the market was saying. They were not willing to pay up to re-establish market access and to begin the process of regaining market confidence.” Another US-based fund manager says: “Brazil and Korea are like two ships passing in the night and headed in opposite directions.”
For all the fear among emerging-market traders and investors, and the illiquidity of secondary markets, the sell-off has not produced much outrageous mispricing of countries’ debt on a relative value basis. “Our own assessment suggests that, with the possible exception of Asia, the market is efficient in establishing the ranking of each country relative to others,” says Simon Romijn, head of emerging-market debt management at Baring Asset Management.
An added risk premium of at least 200bp has attached itself to the market as a whole, but only in Asia are credits trading out of line with their correct relative valuations. Yet markets there are so unstable that few investors would bet heavily on this. The only certainty is that the market is reordering credits within the region, with Chinese assets trading at levels tighter than Korean, Indonesian and Thai paper.
In between the investors fearing a complete rout and those who scent recovery sit the wait-and-see camp. At the end of last year, many investors were torn between their instincts to buy bonds at cheap levels or to stay out of the market, and even to sell, in anticipation of more bad news.
“If you believe the Korea situation will be resolved soon and that international markets will stabilize quickly, you probably should buy into some of the hardest-hit markets like Russia or Brazil,” says Foreign & Colonial’s Williamson. “But if you think markets will remain volatile, then you should stay in less aggressive positions in the stronger credit stories, such as Mexico and Venezuela.” Williamson herself errs on the side of caution. She would rather wait and be sure a strong emerging-market rally has begun before committing new money to buying, even at the cost of missing out on a percentage point or two of performance.
If emerging-market specialists are cautious, then conventional fixed-income investors who started to put money into emerging-market debt for extra yield in 1996 and last year are quite terrified, especially over events in Korea. They are more likely to be sellers than buyers of Korean debt for some time to come. “Their problem is that they don’t want to sell at these spreads. But at some stage they will have to take the hit and accept the 400bp, 450bp or 600bp spreads on offer,” says Romijn at Baring Asset Management.
These potential sellers include managers of high-yield bond funds, who added emerging-market dollar bonds to their portfolios of American corporate junk and, potentially more worryingly, also more generalist bond buyers who sought diversity, yield and performance by buying sovereign and corporate debt from the largely investment-grade countries of Asia. “The biggest technical problem will come if investment-grade accounts are forced to sell South Korean paper due to a downgrade,” says Arthur MacBride, senior vice-president at The Boston Company. On December 22 Moody’s downgraded Korea, Thailand and Indonesia to below investment grade and investors braced themselves for a wave of forced selling. Perversely MacBride adds that this might be a buying opportunity.
The idea that the worst news is not all out is an integral part of contrarian investing. “There are pockets of phenomenal value,” says Ghaffari “and there are pockets of phenomenal terror, especially in North Asia. At times like this there is a predictable over-shoot in both bond spreads and equities. If Korean dollar bonds yield, say, 800bp over treasuries, it will become clear to the market that they offer value, but only when the Koreans start taking the right policy decisions.”
Investors may look at credit fundamentals and think that for many countries these are strong and that spreads are too wide. But that may all be irrelevant if other investors continue to sell. “In some cases the market is being driven by technical factors, rather than real risk-related factors,” says Reiss. Institutional fund managers are looking and listening for any further signs of forced selling by leveraged investors from within the emerging markets themselves. It was among these types of buyers, starting in Brazil, then quickly spreading to Russia and Korea, that the sell-off really began last October. Rumours abound of huge losses at leveraged Brazilian buyers including the banks, although there is a growing sense that the worst of the forced selling is past and much of the leverage squeezed out. “Even anecdotally, there is less talk recently of Brady bonds coming out of places like Korea and Latin America. Some of the paper that was dumped may not have found its way into firm hands yet. But basically, that process is played out,” says Reiss.
Some intermediary bank trading desks, having flattened their positions following the sell-off in October and November, had begun loading up again in early December anticipating a wave of investor buying at the start of this year. But more bad news coming out of Korea stalled this process, leaving investors with another problem. Even if they do decide to buy cheap emerging-market debt, there is no guarantee of putting a large amount of money to work at the quoted spreads. “Secondary markets are extremely thin right now,” says MacBride. Liquidity dried up as dealers declined to take on new positions at the end of last year, making it hard either to buy or sell in volume.
That doesn’t mean active fund managers are doing nothing. There are other ways to exploit the situation apart from simply buying cheap assets and sitting on them until they rise in value. “We are trading volatility, concentrating on a few instruments in countries where we are broadly positive like Russia,” says John Cartwright, director at ANZ Emerging Markets Fund Management. He says that, following a rally in Russian bond prices in late November and early December, as the outflow of hard currency stabilized and spreads on Russian bonds narrowed to 690bp from 750bp a few weeks earlier, the fund sold Russian debt. Following news of president Yeltsin’s acute viral respiratory problem, when bond spreads widened to 820bp, it began looking to buy again.
There are interesting phenomena at work including some yield curve flattenings and inversions. Williamson at Foreign and Colonial points out there have been times when it paid as much to hold Venezuelan DCBs maturing in December 2007 as it did to hold global bonds maturing in 2027. The institution sought to take advantage of such anomalies, by positioning in shorter-dated debt, as have other institutional investors.
Morgan Stanley Asset Management has, at times, found itself able to go long of two-year Brazilian paper yielding 600bp over treasuries and short of 30-year paper yielding 550bp. It has sought value in Russia with a barbell strategy buying very short-dated GKOs with percentage yields in the mid 30s and very long-dated bonds offering up to 800bp over treasuries. By investing in both markets, the institution is also expressing a fundamentally positive regional view. “Real performance this year will be in the large Latin American and large East European markets,” predicts Ghaffari, “and in selective Asian currencies.” And he suggests to any new institutional investor looking for an opportune entry point into emerging-market debt: “Every time you see a headline about Yeltsin being ill, that’s when you have to spend some money in Russia.”
The view is widely shared that once emerging-market debt as an asset class stabilizes and starts to recover, regional performance will be disparate. Many investors prefer Latin America and East Europe for this year and remain extremely cautious about Asia. Research-oriented investors who produce their own internal shadow credit ratings for sovereign borrowers suggest that the independent rating agencies have been slow to catch up with reality. These investors suggested countries such as Thailand, Indonesia and Korea be ranked on a relative-value basis somewhere between Mexico and Argentina – that is, as BB credits – long before Moody’s downgraded them below investment grade late in December.
Surprisingly then, many investors and analysts agree as to where the best value will be found in emerging-market debt this year. It will be in local currency debt, particularly in Asia. Local currencies have been hammered so hard that, investors hope, they will now offer the best chance for good performance this year. Even for many emerging-market specialists, local currency markets until now have been an area more to consider than actually to invest in. Now that currencies have collapsed, the attractions in Asia look more obvious. “I never wanted to buy the Indonesian rupiah at 2,500 to the dollar with local interest rates in single figures,” says Ghaffari. “Now at more than 5,000 to the dollar with interest rates of 22%, it looks very much more attractive. We will devote a lot more money and resources to local currency investments this year.”
For investors who previously bought dollar debt only to benefit from spread tightening, investing in local currency instruments is a new discipline. “There are distinct differences in the risk-and-return profiles of dollar debt and local currency debt. You have to look at different sets of economic statistics,” says Romijn. Baring Asset Management had planned to bring out a local currency fund last year but wisely delayed. This year might be the time for it. Romijn is hopeful for Asian local currencies in the medium to long term. “Asian countries don’t have unsustainable debt burdens and they have many strong export-oriented economies. When their current accounts move into surplus and the capital accounts are in surplus, the currencies could rise very quickly.” The wise money in Asian local currencies probably will flow into those countries which have embraced IMF-sponsored stabilization: Indonesia, the Philippines and eventually Thailand.
Investors are picking out other themes for longer-term investment in local currencies. In eastern Europe, the currencies of Poland, Czech Republic and Hungary may eventually converge with core Europe, as did the high-yielding Spanish and Italian markets in 1996 and 1997.
But not all investors are switching out of dollar paper into local currency instruments. Investors in dollar assets worry at worst about default risk. “If I look at Russia and think about default risk, I think it is very unlikely that Russia will default,” says Williamson. “So I am happy owning Russian dollar paper. But if you asked me would I take a bet that they won’t have to raise domestic interest rates again, I would not be as confident. They may well have to hike rates again, if, for example, there is another attack on the Hong Kong dollar.” She adds: “Certainly local currencies overshoot further than dollar markets. And the Mexican peso has rallied continuously almost from the end of 1994. But I think it is a little early and a little risky to call the bottom for Asian currencies. If you asked me whether I thought the Korean won is more likely to go to 1,000 to the dollar or 2,000, I would say 2,000.”
There is another technical factor which may constrain any speedy recovery in emerging-market debt next year: new supply. During the bull market run in 1996 and 1997 some emerging-market borrowers tried to position themselves ahead of the market by buying back their own debt. That is much less likely to happen in 1998. Rather there will be a heavy calendar of new issues as Asian sovereigns raise funds to try and provide liquidity to domestic corporate and financial borrowers. If the crisis in Asia abates this year, countries may try to replace IMF financing with hefty new issues of their own, so as to regain economic sovereignty. “The supply should be significant,” judges MacBride. “Spreads will remain at relatively wide levels. The upside will be limited in 1998 in part due to the supply.”
Not even the boldest emerging-market bull would suggest that any rally this year will take spreads back to the levels prevailing in the first half of last year or even just prior to last October 22. But there again one of the secrets of clever investing is being prepared to wait.
Even some dedicated emerging-market specialists are in a state of paralysis right now, neither selling bad positions nor picking up bargains. For some, this may be a matter as much of investment style, as inability to read the markets.
More bullish investors won’t remain quiet for long.
