Speculation that European downgrades could squeeze EM corporate bond issuers is overblown, finds Martin Steward

Emerging market corporate bonds are in great shape. A record $300bn (€228bn)worth were issued during 2012, and this healthy supply met with equally healthy demand.
Furthermore, new issuance has not meant a big rise in net borrowing because it is largely down to firms turning away from traditional bank lending. The debt-to-EBITDA ratio for the average emerging market corporate is still only about 1.2 times, versus about 1.8 times for the average US company.

This sunny outlook pervades many a research note from asset managers and investment banks, such as the one published in October 2012 by ING’s global head of emerging markets strategy, David Spegel. ‘EM default risks and distressed debt: trends and outlook’ noted that, for the first time since Q1 2008, the third quarter of 2012 saw net positive ratings changes across every emerging market region.

While Spegel acknowledged that the $11.8bn worth of defaults to that date was more than double the total value for 2011, this number was skewed by two big numbers: a $5bn technical default by Kazakh bank BTA (which was really a default on just $1bn senior unsecured bonds); and a $1.6bn default by Brazil’s Banco Cruzeiro do Sul. Even with this skew, emerging market high yield and US high-yield default rates were comparable over 2011 and 2012. Moreover, only 28% of the emerging market corporate universe is rated below investment grade – include every issuer and the default rate falls from 3%-plus to less than 50 basis points. The two big 2012 defaults are not straws in the wind, either, according to Spegel, who maintained his forecast that in November 2012 default rates would peak at 4.5% before declining rapidly. Despite all this, emerging market BB-rated bonds still trade around 200 basis points above US high yield.

And yet the press headlines generated by Spegel’s note focused on a less reassuring aside. Given that credit markets “are highly correlated globally”, his benign default outlook for 2013 was “highly predicated” on calm being maintained in US and European high-yield markets, and he was “somewhat concerned” that a downgrade of Spanish and Italian sovereign debt to junk status could drag a number of BBB-rated corporates into speculative grades as well.

That would radically change the character of the global high-yield universe; the value coming to maturity during 2013 could potentially rise by a staggering $187bn (figure 1). Emerging market issuers that have to compete with this wave of newly-downgraded issuers for investors’ capital when they come to refinance could find themselves crowded out – and on the brink of default.

The European downgrade part of this scenario is a real possibility. Italy currently sits on a BBB+ rating from Standard & Poor’s; Spain was cut to BBB-, just one notch above junk, in October 2012. But how realistic is the contagion part?

There is a lot to suggest that investors should take it with a pinch of salt. First of all, only a minority of emerging market issuers will be forced to compete for refinancing over the next couple of years.

“We certainly don’t see pressure on refinancing, as quite a lot of companies are taking the opportunity to extend maturities while rates are attractive,” says Jan Dehn, co-head of research at Ashmore Investment Management. “One of the features of EMs is that they are used to the market suddenly cutting off their funding, so they tend to lock it in as and when they can.”

William Perry, an emerging market debt portfolio manager with Stone Harbor Investment Partners, which also specialises in global high yield, agrees. “The only place where we see a concentration of short-term maturities is China high-yield – a lot of property developers issued five-year bonds in 2010,” he says. “But even that market is now in favour and they are starting to issue long-dated bonds, too.”

Second, the re is the question of how much these issuers compete for the same capital as European corporates. Of the $1trn of outstanding emerging market corporate debt, it is true that only about $45bn is held by dedicated managers benchmarked against the JPMorgan Corporate Emerging Markets Bond index (CEMBI) – although that segment is growing rapidly. However, the biggest investors are emerging markets managers benchmarked against JPMorgan’s EMBI or equivalent that can allocate 15-20% to corporates, where there is still no overlap with developed market high yield.

The rest is held by global credit managers. While a small number of global high-yield managers consider the occasional emerging market credit, they are very bottom-up and tend to be based in the US and focused on US issuers – not European. The European institutions that buy European high-yield are conspicuously absent from emerging market corporate bonds.

“It’s very rare that we get a call from a broker saying: ‘We have a European seller of XYZ bond’,” says Perry. “If we do it’s usually a bond issued from one of the CEEMEA countries, typically Russia, Emerging Europe or Turkey.”

Correlations between developed and emerging market high yield inevitably rise in very volatile markets, but even that has never fed into defaults caused by a funding squeeze.
“We will see defaults in our asset class, but typically from the companies with inherently bad business plans, not due to lack of funding for good companies,” says Perry.

One reason for the lack of longer-term spread correlation and the expectation of falling emerging market default rates is the rush of new capital into hard-currency debt in response to the global shortage of credit. As Istvan Fritsche, senior client portfolio manager in emerging market debt at ING Investment Management, points out, the $200bn worth of US high-yield issuance in 2012 did little to soak up the year’s $700bn of coupon amortisation. Where has that $500bn gone? Into emerging market corporates.

“So there is that channel between DM and EM corporates,” he observes. “But it is about a capital overhang from DM, the opposite of crowding out.”

Still, Spegel’s point was not that crowding out is happening today, but that it might if global high-yield swells with peripheral European paper tomorrow. Would that paper suck that capital overhang away from emerging markets?

Probably not, according to Fritsche’s colleague at INGIM, Nish Popat – because investors increasingly recognise the quality of emerging market issuers relative to those in developed markets. And this is not primarily about global high-yield allocators preferring high-yield issuers whose ratings are improving versus those whose ratings are deteriorating, but rather investment-grade allocators looking for attractive risk-adjusted spreads.

“If anything, the European downgrades we have seen so far have caused problems for investment-grade investors who have had to switch out of certain issuers,” Popat notes.
“That has driven the structural shift into EM corporates rather than short-term speculative flows. They see how positive the fundamentals are and the excess spread they are able to get.”

Headlines about contagion from peripheral European junk are sure to concern investors making their first meaningful allocations to emerging market corporate bonds. But remember, almost three-quarters of emerging corporate issuers are investment-grade, and the biggest change happening today is the inflow of like-minded ‘real money’, with an investment-grade mandate, into that universe. The capital overlap between developed market high-yield and emerging markets was always modest; if anything, in relative terms it appears to be getting smaller.