No end in sight for emerging market bond woes
It’s been a torrid year for emerging market local- and hard-currency bonds. After a 2012 rally, credit picking has reigned supreme and the conventional investment case – emerging markets are at a different stage of the credit-rating and growth cycle than developed market issuers – took a knock.
The events of the summer of 2013 turned the investment case for many emerging markets upside down and triggered a rush for the exit that has led many credits to slide precipitously throughout the second half of the year. Although emerging markets had been something of a safe haven in many cases, from the plight of Europe in particular, the mere mention of the forthcoming end of Federal Reserve quantitative easing was enough to reverse the trend.
Rising GDP, however slight, and inflation that seems thoroughly anchored have also transformed the investment case for developed economies, with equity markets being especially frothy. The result has been the sucking of capital away from less-developed economies, where inflation tends to be higher and GDP growth has been slowing.
As commodity prices fall, along with the value of the dollar that most commodities are priced in, many emerging markets that rely on commodity exports have lost the turbo charge that had been propelling them for years. Local-currency bonds (about -7%) underperformed hard-currency sovereign (about -5%) and corporates (about -1%) this year.
The underperformance has not been spread evenly. Asia – especially ex-Japan and ex-China – remains an investor favourite, with countries such as Vietnam and Indonesia, less reliant on commodity exports, outperforming relative to eastern Europe and Latin America. Big economic powers Brazil and Russia have been among the poor performers. In Asia Pacific, says Moody’s, "four-year refinancing needs appear to be manageable". Non-financial corporate debt issuers have $378 billion of domestic and cross-border bonds due through 2017, it says, around 88% of which are investment grade and 66% of them domestic bonds. "Most companies should be able to address their maturities given market appetite for their bonds," concludes Moody's.
Yet even Asia saw above-average numbers of downgrades in the third quarter of 2013. Standard & Poor's downgraded 34 emerging market issuers – 60% of total rating actions, higher than the region's 18-year average of 51%. Latin America was worst hit, with 20 downgrades, 13 of which came in Argentina. Eastern Europe, the Middle East, and Africa and emerging Asia had seven downgrades each. According to Fitch, there have been nine emerging market company defaults on $7.7 billion of dollar-denominated bonds from January to end-November, compared with five issuers and $2.9 billion for 2012. “The par weighted average recovery rate on 2013 defaults fell to 45.4% in October from 55.4% in September, mostly due to bonds issued by Eike Batista's OGX group, an oil-and-gas-drilling operation, which traded at a low 8.7% of par following default.
Yet even in the more troubled markets there have been opportunities for credit pickers willing to do their homework. “This year investors have succeeded by making careful decisions on securities only after scrutinizing balance sheets and management teams, and identifying pockets of opportunity, while avoiding defaults,” says Shamaila Khan, portfolio manager for emerging market corporate bonds at AllianceBernstein. “Latin America showcases the point. Default rates there have been very high, but investors who avoided the region altogether missed out on some great opportunities. The problems weren’t systemic – they were idiosyncratic.” But credit picking in emerging markets such as Brazil has been fraught with difficulty. Take OGX Petroleo e Gas, the Brazilian energy company that in October became the largest emerging market corporate external debt default in history. Many investors were caught out because reliable information about the company’s reserves was so hard to come by, says Khan. When the company admitted it would miss production targets things started to unravel. “For bond investors, the downside risk was large, while the upside was small compared with stocks,” she says.
Khan adds: “Successfully investing in EM corporate debt requires evaluating a range of risks, including the idiosyncrasies of shareholders, managements and local politics, and changes in regulations. Investors can’t rely on riding a wave of beta.”
None of these issues is unprecedented. “Seasoned emerging market investors are often offered the opportunity to watch the same movie play out in different markets at different times,” says Matt Linsey, manager of GAM Star North of South EM Equity, who has been watching the bond markets closely to inform his equity allocations. He cites emerging market crises in Thailand and Russia as forerunners of the problems now being experienced in South Africa, Turkey and India.
Linsey says that by summer 2013: “Fixed-income investors realized that they were being offered below-inflation returns to own risky foreign-currency emerging market government bonds.” Unfortunately, because EMs are often by definition smaller and less liquid than developed economies, many investors owned large proportions of domestic bond markets, complicating their exit and leading to a sharp correction in their currencies.
However, Linsey feels this has created an opportunity in India. “The 25% correction in the rupee by August this year has created opportunities – especially since India boasts a number of companies with foreign earnings,” he says. “The appointment of a new reputable central bank head may have proved a turning point for the currency and the market.” Idiosyncratic and political risk has also loomed large at the sovereign level. Western investors have had plenty to worry about in their home markets, with concerns about the future of Europe and the longer-term implications of austerity.
Dealing with politically unstable or unpredictable emerging markets has been a bridge too far for many, acting as a further catalyst to the flow of money into developed economies. Be it Ukraine, Syria or Iran, the relative weakness of political institutions in many emerging economies adds an unwanted level of risk that many investors do not feel prepared to take in the current climate.
“Where is the gamma in these markets?” says Louis Gargour, CIO and managing partner at LNG Capital. “We recommend hedging long positions in developed market bonds with shorts from some of the weakestl-ooking EMs, particularly in the CIS and Eastern Europe. The logic is that if the markets sell off, the moves will be more dramatic in the higher-yielding bonds, more than covering the losses on the long book.”