Deep water

Emerging and frontier market bond issuers have been taking advantage of abundant liquidity but investor appetite may be cooling as warnings about debt grow.

Record debt financing by emerging market issuers taking advantage of deep pools of liquidity are beginning to generate jitters that they may be getting out of their depth.

Appetite for risky assets cooled in August, and in September the International Centre for Monetary and Banking Studies in its annual Geneva Report warned that a “poisonous combination” of record debt and slowing growth could presage another global crisis.

Most estimates point this year to at least US$400bn of issuance by EM sovereigns and corporates – vigour that has taken some by surprise.

Adam Borneleit, a product manager at BlueBay Asset Management, said: “Initially, we thought new issuance would be a lot lower this year, especially after the spike in rates last year and some concern around the fragile five EM countries, and at the beginning of the year issuance was a lot lower.

“It picked up in the summer, although total issuance will still be a tad below last year’s: JP Morgan’s estimate for this year is about US$337bn of new issuance in EM corporates and that compares with US$362bn last year, so roughly US$25bn less in issuance this year than last.”

“Precipitous” fall

Paul Tregidgo, vice-chairman of DCM at Credit Suisse, points out that these high levels come despite a “precipitous” fall this year in Russian and Russian-related issuance – which last year made up about 13% of the US$420bn coming to market.

“JP Morgan’s estimate for this year is about US$337bn of new issuance in EM corporates and that compares with US$362bn last year, so roughly US$25bn less in issuance this year than last”

“We are on pace for a record year out in the EM debt markets and that is doubly impressive when you consider a major player – Russia – has not been a significant part of that supply. Investor demand continues to be strong across the entire corporate sector – investment-grade and high-yield,” he said.

Data from Thomson Reuters in July showed international sovereign bond sales reaching US$69.47bn in the first six months of the year – a staggering leap of 54% on the same period in 2013. Notable issues were Kenya’s US$2bn debut and Ecuador’s US$2bn comeback.

Marcus Svedberg, chief economist at emerging and frontier markets asset manager East Capital, believes greater EM issuance in bond markets is merely a reflection of increased activity across the board.

“We have had lots of interest in all different kinds of emerging market assets; in corporate debt, in both local currency debt and FX, and in different high-yielding products – and to me it is a sign that, despite all the problems that we are having in the world, there is lots of liquidity and lots of appetite for yield,” he said.

While many sovereigns have done relatively well in recent years, pick-up in demand for EM corporate issues, which offer significant spread gains over developed markets, is a key feature of the market. There has also been growing issuance in euros because of a cost arbitrage and the desire among strategic issuers to diversify their investor base.

Borneleit at BlueBay said: “Dollars are always a big liquid market, but what we have seen this year is that there has been growth in euro-denominated issuance as a proportion of the total, and that makes sense – the euro economy is a bit weaker, European rates are lower, and the view is that those rates will stay lower for a bit longer than in the US. That said, it is still small – €33bn compared with US$217bn year to-date [as at September 15].”

Investment-grade debt, driven by Chinese and Latin American state-owned enterprises, has also grown at the expense of high-yield.

The regional picture suggests the big issuers are China – whose state-owned enterprises have driven Asia ex-Japan – and Brazil and Mexico, which have benefited from an apparent flight to safety as supply out of emerging Europe shrinks.

Tregidgo of Credit Suisse said: “The market that has outperformed in terms of volume has been Asia ex-Japan – last year the region contributed US$115bn of issuance; this year it is already at US$125bn, of which China makes up nearly 50%. Within that, you have got the corporate high-yield market, which has been predominantly centred on China, the most significant portion of which has been the real estate and property sector.”

“We are on pace for a record year out in the EM debt markets and that is doubly impressive when you consider a major player – Russia – has not been a significant part of that supply. Investor demand continues to be strong across the entire corporate sector – investment-grade and high-yield”

Issuance is likely to continue growing in the short-term as state-owned banks in China come to market for Tier 1 and Tier 2 capital.

Latin American vigour – fired by Petrobras – has surprised many bankers who had thought the region would struggle in the face of US rate fears, slower growth and elections in Brazil.

African frontier markets have also been diving into the dollar market. In June, Kenya issued two tranches of a maiden Eurobond issue (US$500m due 2019 and US$1.5bn due 2024), joining only a handful of African states to have done so.

“Africa is taking advantage of a very specific situation: just look at Argentina, where bond investors are nervous, problems in parts of Asia, the Ukraine crisis – so when you have got a lot of institutional investors with large pensions liabilities they have to find a pick-up in yield, and Africa is providing that at the moment, said Angus Downie, head of economic research at pan-African bank Ecobank.

Between a rock and a hard place

“In some ways investors are caught between a rock and a hard place so they are driven into these African issuances on the Eurobond market because there’s not much else available that is credible, although credibility will be tested once US monetary policy starts to tighten,” said Downie.

In South Asia, scarcity value and banking improvements enabled Sri Lanka’s National Savings Bank to offer US$250m of five-year bonds in September. India remains quiet despite optimism surrounding the election of Narendra Modi earlier this year – although telecoms company Reliance signalled in August plans to issue debut US dollar bonds, and there have been clear signs that there will be huge funding needs for infrastructure development.

Alongside regional factors, longer-term trends are also at play. Emerging markets are predictably taking advantage of low rates to refinance shorter-term debt amid abundant liquidity. Bulls also predict that growth within the largest EM countries, excluding China, is expected to rise in 2015 – the mix of higher growth and lower debt-to-GDP levels than in many developed economies making EM debt a prime destination.

The bond market is also reflecting a longer-term improvement in the access of developing nations to the credit markets. While emerging market bonds still trade at higher yields and risk premiums than developed-market bonds, those risk premiums may be falling.

Emily Chew, senior analyst at MSCI, the index and portfolio analytics provider, believes that investors are increasingly looking at the performance criteria of individual EM corporates as opposed to making broad-brush judgements on the basis of what is happening in emerging economies generally.

“Investors want to be able to access the emerging market story. I think that all too often we are lumping together very diverse situations and companies under this one umbrella called ‘emerging market’ but if you’re looking at quality indicators – if you are using ESG [environmental, social, and governance] metrics, for example – these indicators can be an even better signal of a quality company than in the developed market context,” she said.

This seems to be corroborated by the MSCI Emerging Markets ESG Index, which since launching in Q2 2013 has consistently outperformed its parent index.

However, the longer-term outlook for EM debt is not without challenges and some observers believe investors have been taking risks as underlying fundamentals deteriorate.

In Europe, rates are likely to stay low but it remains to be seen what will happen to flows once major central banks start to withdraw quantitative stimulus and interest rates start to rise in the US. The Bank for International Settlements is among those now warning of the dangers posed by rising debt burdens.

Although developing governments have gradually weaned themselves off the addiction to dollar debt since the 1990s, there have been signs of nervousness since early September, when expectations of a broad-based rally in the dollar triggered a fall in EM equities.

In August, the Institute of International Finance highlighted sharply falling portfolio and bond flows to EMs and warned of a cyclical turning point.

The frailties may first become apparent in Africa, where countries have been issuing at a furious pace. Two of the first African countries to tap the sovereign bond market – Ghana and Zambia – have already sought talks with the IMF after taking on too much debt. Ghana appears to be carrying on regardless, selling a US$1bn Eurobond issue in September.

“Investors will be asking some really pertinent questions to the Ghanaian authorities about the sustainability of their economic policy environment and how they see themselves repaying not only this new Eurobond but also previous Eurobonds,” said Downie of Ecobank.

He believes the Ghana issue raises broader questions about how sustainable it is for many of the African economies that have come to the Eurobond market to keep accessing it when US interest rates start to rise, and points to high “rollover” risk.

He said there was strong desire by African sovereigns to tap into some of this liquidity given the low interest rate environment – but on the investor side you have got to question the wisdom of investing into these somewhat fragile economies with the expectation they will be able to repay all the interest plus the principal at maturity successfully.

“It’s possible, but we are in uncharted territory and in some ways this locks African sovereigns into re-issuing – if they can afford it – in order to pay off past principal,” said Downie.