Standard Chartered and HSBC were an obvious focus when emerging-currency strains led to disruption in debt and equity markets in January and early February, as the sole members of the $2 billion club of banks generating at least that amount of investment banking revenue from emerging markets in 2013, according to an estimate by JPMorgan analysts.
BBVA and Santander were given a surprising pass by investors when markets were rocky, given their heavy reliance on Latin American revenues, both in retail and investment banking. The effect of real-money buyers lumbering into an overweight position on peripheral European markets seems to have been enough to counteract any concern about LatAm exposure at the two Spanish banks, and an upgrade for Spain’s sovereign rating by Moody’s on February 21 sealed the impression that all is now for the best in the best of all possible Iberian worlds.
There are lingering reasons for concern about investment banking revenues at some firms that do not have substantial direct exposure to emerging markets, however. Credit Suisse derives around 20% of its fixed-income revenue from emerging markets, for example, which is roughly double the proportion at Goldman Sachs and around four times the weighting at big European banking peers or Morgan Stanley.
That highlights the inherent fragility of elements of the Credit Suisse business model – an area where the bank is always a market leader in terms of exposition, but often struggles to deliver when it comes to tangible results.
The bank’s progress can resemble an elegant high-wire act, where poise and apparent balance can divert the eye from the risks that await the slightest mis-step.
Credit Suisse has made the transition away from over-reliance on fixed-income revenues better than competitors such as Deutsche Bank or Barclays. It remains in the top three for equities earnings – just – and has a credible issuance and advisory franchise to balance the roughly 40% of investment banking revenue that came from fixed income last year.
It is within fixed income that the risks of the bank’s high-wire act are highest. Credit Suisse is attempting to focus on its traditional areas of strength, such as high-yield credit and emerging markets, while remaining a credible player in sectors such as rates that are suffering from falling margins, but remain the main source of revenue.
Credit Suisse described its target sweet spots within fixed income in its last earnings release as "high-returning yield businesses". That certainly sounds attractive, but the emerging market turmoil of the first two months of the year provided a reminder that high returns inevitably come with elevated risk.
For Credit Suisse, as for other investment banks, the hope is that increases in risk are accompanied by differentiation between markets and within markets, and that a shift from an environment where central banks hold down volatility can be made without turning off the yield taps for long enough to disrupt revenue generation.
High-yield credit as an asset class shrugged off the effects of the emerging markets disruption in January and February with impressive ease, which bodes well for Credit Suisse. By late February, European high-yield paper had appreciated by almost 1.7% year to date and US indices were up by 2%, with absolute yields in both regions nudging historical lows.
This could push the few remaining hedge funds that were running meaningful short positions in high-yield credit to throw in the towel and confine their bearish views to purchases of tail hedges.
Expectations for another year of healthy high-yield issuance remain in place. And the trend towards greater disintermediation in Europe, as an originate-to-distribute model by banks delivers more borrowers to the capital markets, also remains intact. That should ensure the long-term health of high-yield credit, even if the effect of rising rates causes disruption and exposes some of the loosening of credit protection in deals.
But the successful broadening of global capital market access in recent years might cause problems where high-yield risk intersects with emerging market issuance. Analysts at Bank of America recently highlighted the extent to which emerging market borrowers have been able to boost their issuance of US dollar debt since 2009 and identified an undercounting of external debt of $318 billion in balance-of-payments data.
The analysts arrived at this estimate of undercounting by comparing a total of $1.04 trillion of externally issued bonds by emerging market nationality with the $742 billion of this amount that was sold by residence of the borrower, with only the latter showing up in standard balance-of-payments estimates.
"External bond-issuing EM non-financial corporates are behaving as quasi-financial intermediaries, executors of a vast carry trade," the analysts said, predicting unwinds and global market disruption as the Federal Reserve tapers its policy.
A full-scale unwind of dollar debt by emerging market corporates might be avoided in the near term, but there has already been a slump in issuance of new bonds, in the face of Fed tapering and domestic-currency instability for potential borrowers.
While both investment-grade and high-yield developed market corporate issuance barely missed a step, even when there were losses across all asset classes in late January, emerging market debt sales dried up and struggled to resume even when currency markets stabilized.
This trend did not have an immediate effect on issuance and advisory income at Credit Suisse. By mid-February Credit Suisse was at close to its run rate for the same period of 2013 for combined debt and equity issuance and M&A fees of around $650 million, according to Dealogic data, while peers such as Deutsche and Citi were 20% or more behind the previous year’s results.
Any effect of emerging market disruption on overall fixed-income sales and trading revenues at Credit Suisse and other banks will not be apparent until later in the year.
Volatility itself is not a bad thing for the embattled fixed-income franchises of big dealers – far from it. It was a combination of low volatility, customer uncertainty and reduced opportunity for gains from inventory management that caused the slump in fixed-income earnings in the second half of last year.
Fixed-income dealers need a certain type of volatility to revive revenue, however. Differentiation between borrowers and dispersion within indices should be good for dealers, whether Fed tapering is pushing up rates or not. But any shift to a risk-off attitude across markets would deliver a serious blow to banks that remain reliant on fixed-income earnings.