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Tuesday 19 March 2024

Arranging banks (on behalf of bond issuers) typically release the initial price talk (IPT) at the same time as the announcement of a bond deal. It is seen as a crucial tool for new bond price formation and is traditionally stated in yield terms for high yield (HY) and spread over benchmark (or swap curve) for investment grade (IG) bonds. From an investor’s perspective, spreads are the better way to analyse value in a bond because the benchmark rate can change over the course of the new issue process (we have seen some significant moves in the past couple of months) and diligent investors will transpose yield into spread terms.

Once the book building process has started, banks release updates on pricing (e.g. price guidance) and it is almost exclusively one way: tightening. This stage allows banks to test the order book with an improved pricing for their client (the bond issuer). After the guidance is released, if investors pull their orders below the targeted issue size, then the tightening has been too aggressive. Conversely, if investors stay in the deal and the order book is still multiple times the targeted size of the new issue, then there is room for further tightening. In reality, this process is more of an art than a science and there are many other factors that influence pricing, such as market conditions, quality of the book, issue size, flows, secondary trading success, and obviously the issuer’s view. Taking all of these factors into consideration, banks release final pricing.

I’ve always hit a wall when I have asked a few banks if they had any statistics on initial price talks vs final pricing of newly issued bonds. I therefore decided to crunch some numbers looking at emerging market (EM) sovereign and corporate USD-denominated bonds issued in 2023. In the IG space, results were a bit of a shock, so I also ran statistics on developed markets (DM) to see if this was EM-specific. In total, I have reviewed over 1,100 bonds, denominated in US dollar and issued in 2023: c. 900 IG bonds issued by developed market corporate bond issuers and c. 250 EM sovereign and corporate bonds (165 in IG and 77 in HY). Here are a number of observations:

  • Not a single deal priced wider than IPT. Only ten deals (<1%) priced at the initial price talk.
  • EM IG deals tighten significantly in absolute terms. Within the sample, spreads tightened by a median of 35bps (average of 34bps) with a range of 0 to 62bps. This is rather counterintuitive: 30 basis points can mean a lot in the IG world, where issuers generally have a bond curve which should make pricing of new bond fairly simple; however, HY issuers may only have one (or even no) bonds outstanding, which means that price discovery is genuinely needed… We discuss below why IG IPTs are often set at somewhat ridiculous levels.
  • EM IG deals tighten more than HY deals. Whilst in absolute terms, HY deals tighten by a larger amount (range 0-125bps), in reality they tighten much less than IG as a percentage of initial spreads offered at IPT. EM IG deals saw an average tightening of 21% with some of them as high as over 50%. EM HY deals tightened on average by 8% in spread terms, with a maximum range of 25%. The median tightening of EM IG is 35bps vs 33bps for HY.
  • DM IG ($) deals tightened by a median of 25bps vs 35bps for EM IG ($). As a percentage of initial spreads offered at IPT, DM IG averages 15% (range 0-50%) vs 21% for EM IG.
  • With less than 10% spread tightening on average for EM HY, IPT seems to offer a credible starting point for price discovery of less liquid asset classes.
  • There seems to be a geographic bias to tightening. In 2023, the top 15 EM IG deals that experienced the most tightening are all from China. They are followed closely from South Korea. Interestingly, within IG the region that saw the least tightening (in USD) was Eastern Europe (Romania, Hungary) – likely due to reduced demand for US dollar paper.

Based on the above observations, the relevance of IPT as a price discovery tool in EM IG is questionable because they are consistently unrealistic. Using an analogy with the residential property market, what would be the point of intentionally marketing a house 25-50% cheaper than its fair value if not for the sole purpose of building interest of buyers that would otherwise not bother?

There is no doubt that a massive order book on the back of an unrealistic IPT presents the illusion of a successful deal. But syndicate banks argue that (i) they face reputational risk of a failed deal, hence they must play safe by setting higher rather than lower IPTs, (ii) some investors themselves don’t stick to their Indication of Interest (IOI) and too often communicate inflated pricing interest ahead of the deal, and (iii) at IPT investors still retain a free option to pull their order if the deal tightens later on. Whilst the “free option” argument is true, asset managers as investors have many psychological biases, in particular commitment bias and waste avoidance, that may alter good judgment and lead to them not pulling their order.

On the buy side, when a new bond deal is announced, hours, sometimes days of research have already been performed by the credit research team. The portfolio management team discusses the deal together with the research that has been produced, analyse the risk/reward of the bond security, its relevance to portfolio construction, etc. In addition, the data management team, fund manager assistant team and so on ensure that the relevant security is well set up in the order management system and upon a decision to invest, a number of additional checks are performed (e.g. pre-trade compliance) and the dealing desk finally communicates the order to the banks. Many individuals/systems are involved in this process and the allocation of resources is significant.

So when IPT comes very attractive, an order is placed, and final pricing comes after unreasonable tightening, it is the responsibility of the portfolio management team to maintain strong discipline and pull their order, i.e. fight a tendency to stick to an original order (commitment bias), for which a lot of resources and time have been deployed (waste avoidance). It is admittedly more difficult to pull an order at the very end of the process rather than to pass on an opportunity ahead of that same process.

Again using the property market analogy, it is never easy to pull an offer where a seller increases the price of a property just before exchange and after months of due diligence by the buyer. As long as investors do not apply strict discipline on pricing by setting a limit – and, more importantly, sticking to this limit – it is likely that emerging market IPTs in the IG space will continue to be used by banks as a book-building momentum tactic as opposed to what it should really be, a genuine price discovery tool.

I just returned from a week-long research trip in Brazil where I met with several local investors and corporate bond issuers. From a fundamental standpoint, I came back more bearish on the country’s fundamental outlook. The macro outlook is challenging and low growth and high interest rates are taking their toll on various sectors. Policy risk is elevated with the new Lula government and the bond market is pricing it to various degrees. Against this backdrop, we favour local currency over hard currency in Brazil but find opportunities in high-yield corporate bonds issued in US dollar in sectors that benefit from global trends (e.g. China reopening) and some idiosyncratic stories less correlated to the Brazil macro noise.

Politics have taken centre stage. The new Lula administration has not been well received by the business community at all. For context, Lula was particularly vocal about the central bank during my trip. At best some corporate issuers and a few local investors expect words to not be followed by action and some said that the new Finance Minister, Fernando Haddad, in private was much more sensible than the government public statements. Other investors expect the worst from Lula with fiscal slippage on the back of increased government spending to revive growth and they do not give him the benefit of the doubt. Lula is seen as an excellent politician and locals believe he will be able to secure a majority at the Congress. Brazil’s political checks and balances may therefore be weaker than the counter-powers facing left-wing governments in Chile, Peru or Colombia (the Latam pink tide). On the positive side, a consensus emerged that Lula was taking Brazil back onto the international stage and that investments in the green economy and protection of the Amazon forest were much needed. Interestingly, absolutely no-one mentioned the Brasilia riots during my trip.

The macro outlook is challenging and Brazil has been facing a mini credit crunch since the beginning of the year. Growth is expected to slow down materially, from 3% last year to 0-1% in 2023. Inflation has been slowing down (5.77% Jan. print) but should remain in the mid-5% for the full year. Against this backdrop, local interest rates are very elevated at 13.75% and should remain so for longer – likely until the summer. Low growth combined with higher interest rates are hurting most companies. Whilst mortgages and consumer NPLs are on the rise, this is not a worry for the moment because individuals have fixed-rate loans. More worrisome, companies are heavily loaded in local floating-rates notes – bank loans, and double-digit rates have been making debt service a challenge in the context of low growth. The recent default (USD and local bonds) of Lojas Americanas – one of Brazil’s largest retail chains – is seen as a one-off by most market participants because it was likely related to fraud (under-reporting of $4bln of supplier financing debt). Nevertheless, it added fuel to fire and has made investors and, in particular, local banks very nervous about corporate governance across the Brazilian complex. The surprise hiring of a financial advisor by Light SA, a large utility in Rio de Janeiro, also took the local market off-guard.

For the USD bond market in Brazil, risks are skewed to the downside because the sovereign dollar curve looks not to be pricing a scenario where the new Lula administration under-delivers for the budget announcement (growth agenda vs fiscal anchor). Therefore, we find hard-currency sovereign debt expensive. State-owned companies’ bonds similarly look unattractive for the most part with very tight spreads over sovereign, in our view not pricing in Lula’s policy and vertical integration risks. This is particularly true in the oil and gas sector. In the corporate space, high local rates for longer in the context of low growth would lead to more defaults locally, itself increasing the risk of a credit crunch.

Source: M&G, Bloomberg, JP Morgan CEMBI BD Index Z Spreads, 20th February 2023.

The Brazilian USD corporate bond market has nonetheless priced in some of the bad news already with credit spreads underperforming their Latam counterparts in the past couple of months (see chart above) and they also trade wide against their 5-year average. This creates investment opportunities in sectors which have been holding up well, such as miners (a China reopening story), the agribusiness, or the more niche private healthcare segment. On the other hand, we remain cautious when it comes to the logistics and consumer sectors because of high interest rates locally and the low growth outlook.

We currently find more value in FX: Brazil’s strong balance of payments and the expectation of higher rates for longer should support the Brazilian Real. Rates also offer high positive real yields (nominal yields adjusted by inflation expectations) after the central bank of Brazil adopted a proactive approach to increasing rates ahead of the Fed in the past couple of years. However, we are slightly more cautious on rates than FX as we don’t discount the risk that the governor of the central bank leaves or negative macro and/or political developments materialise in the short-term (e.g. inflation target, budget announcements). In a worst-case scenario, a saying I heard from a local investor during my trip comes to mind: “we Brazilians are very often at the edge of the cliff, but we never fall”.

The political landscape in Latin America over the past 18 months – from Boric in Chile to Petro in Colombia more recently – has changed to varying degrees but only in one direction: to the left. Some have coined the change the pink tide, others the pink wave. I like the image of a pink tide, slower but mightier than a wave. This pink tide may expand in a couple of weeks if Brazil’s presidential election sees Lula winning, in what is expected to be a tight second round against incumbent Bolsonaro. I am just back from a two-week research trip in Latam (Mexico, Chile, Peru and Colombia) where I met with several corporate bond issuers and local investors and I came back with a mixed view. On the one hand, policy risk has materially increased and the business environment has changed in some countries. On the other hand, I find value in Latam corporate bonds in US dollar relative to other regions of emerging market debt.


Source: M&G, Wikipedia Oct 2022, countries with members of Sao Paulo Forum ruling parties (Pink) and  non-Sao Paulo Forum ruling parties (blue)

From a fundamental standpoint, businesses in the region are in decent shape even though policy risk has already impacted some of them. Utilities have seen credit metrics deteriorating recently, but the starting point is strong in terms of balance sheets. The oil and gas industry benefits from high oil prices but is vulnerable to tax and environmental regulation, notably in Colombia. The demand outlook and market imbalance for key metal-based commodities should provide support for miners in general but Chinese GDP – as a key demand driver – remains a question mark. In the retail space, profits have been impacted by margin erosion due to input cost inflation but top-line numbers continue to stay strong, sustained by consumption. Refinancing risk is moderate and Latam HY default rates are expected to be low-2% in 2022, and moderately higher next year. In terms of valuation, Latin American corporate bonds in US dollar offer a spread of 480bps over US Treasuries – a wide level not seen in 6 years (excluding the pandemic). In 2016, default risk was much higher after the region got caught in a wide-spread corruption scandal originating in Brazil and credit metrics were weaker too. Political risk has increased in many countries in the region but one may argue that the increases in geopolitical risk elsewhere – e.g. Eastern Europe, US-China – are more lasting and worrying changes for asset prices in the medium to long term.

Here is my takeaway on the four countries I visited, how the business environment has changed (or not) with the pink tide, and the implications for bond investors.

Mexico

  • Probably where the macro outlook is the most stable. Leftist president Lopez Obrador (“AMLO”) is very popular in the country – notably thanks to its elderly population’s pensions and the perceived fight against corruption – whilst not so popular with the business community. Strong consumption is driving the economy and most companies I met have strong top-line growth. However, higher input cost has had an impact on businesses that are unable to pass through the entire cost inflation to end clients (margin erosion) or those which are prevented do so by regulation in the energy sector (working capital needs are elevated on lagged payments of subsidies). The Russia/Ukraine conflict in Europe and the US-China geopolitical tensions are all seen to benefit Mexico in the way of US nearshoring.
  • Inflation, like elsewhere, is a question mark. The government expects 3.2% next year but this is well below economist forecasts of mid-4. Banxico continues to keep a high premium over US rates and the Mexican Peso has been stable and outperforming many other peer currencies this year. The current administration, despite its left-leaning rhetoric, is actually praised by investors for its fiscal sustainability. Both deficits and debt levels are low, and the government’s 2023 budget proposal is unlikely to put fiscal stability at risk.
  • State-owned Pemex continues to be the “elephant in the room” with tight liquidity and an insolvent balance sheet that requires a constant lifeline from the government, despite this year’s elevated oil prices. Local investors think the AMLO administration will provide support at any cost. Going into the next presidential election in 2024, there is a wide expectation that the left (Morena party) will stay in power and back Pemex whatever it takes.

Chile

  • For decades, everyone forgot that Chile was located in South America. The business district of Santiago does look modern, but other areas of the city nonetheless still have visible signs of the 2019 unrest in which over a million people protested against social inequality. The election of a young (now 36 year-old) left-wing President in 2021, Gabriel Boric, paved the way for a referendum to change the 40-year-old Chilean Constitution. Too controversial, the new Constitution was rejected in September 2022 by over 60% of voters. Since then, the leftist government has lost a lot of political capital and locals expect another – more sensible – Constitution should be presented within 24 months.
  • Chile’s economy relies much on the mining industry and most of the key players I met reiterated the importance of China for copper (50% of global demand). Marginal copper demand should also come from India and Asia ex-China in the future, driven by electric vehicles and renewables. The outlook is even brighter for lithium (the country has the world’s largest reserves) which displays an impressive demand outlook (2021 was +50% yoy; YTD 2022 +40% yoy; min 25% per year until 2025) on the back of electric vehicle sales in China and Europe. Both copper and lithium miners are facing risk of increased royalties with the proposed tax reform.
  • The non-mining sectors have experienced various trends. In retail, margins have been under pressure due to input cost inflation, but businesses are generally solid with strong balance sheets, and they benefited from both higher spending from early pension withdrawals and a strong rebound in consumption after Covid. The telecom sector is unique in Latam in the sense that it is the most disrupted in the region – too many players and an inability to increase prices have resulted in weaker credit profiles over time (e.g. VTR). Utilities are impacted by the fact that Chile is a net oil and gas importer and most companies have shown working capital pressure with impacts on credit metrics.

Peru

  • Lima is not Santiago. Roads are noisier, streets are busier, and Lima felt overall livelier (day and night). Politics too. As of late August, in average a new minister has been named every six days since ex-teacher and unionist Pedro Castillo became president in July 2021. Castillo’s reputation varies from “poor” to “bad” in the business community. More surprising though, it seems that the population blames the president for high inflation. Although higher prices impact most countries around the world, food is a very large item in the inflation basket in Peru and the weak Peruvian sol is only amplifying the effect.
  • The mining sector (10% of GDP and 60% of exports) is carefully monitoring upcoming policy impacts. For instance, the government is trying to force miners to put on payroll most of their contractors (a measure that happened in Mexico last year and had a small impact) and royalties will go up in copper mining. Similarly to Chile, miners have seen cost inflation across the board in Q2: explosives, transportation, steel. However, unlike Chile, electricity prices are competitive because Peru produces (and exports) gas. In the third quarter, inflation has seen a slowdown.
  • I also had the opportunity to meet with local Peruvian pension funds. The mood was rather bleak. Partly because pension withdrawals over the past couple of years (as a source of income for households during the pandemic) halved pension funds’ asset under management. But also because there was a general sense of resignation about Peru’s political outlook. Castillo has faced two impeachment proceedings since he took office – both failed, but corruption allegations continue, and political stability is never granted.

Colombia

  • The most recent addition on the Latam pink map (before Lula in Brazil?), former guerrilla fighter Gustavo Petro became Colombia’s new president in June 2022. Petro is a more seasoned politician than Castillo in Peru and more experienced than Boric in Chile. He appointed in August a market-friendly Finance Minister (José Antonio Ocampo) and quickly introduced an ambitious (and ever-changing) tax reform proposal with a new oil and gas export tax (allegedly abandoned), the non-deductibility of royalties, a corporate income tax surcharge of 10% (increased from the 5% proposed at the time of my trip) for oil and gas and financial institutions, as well as higher income tax on wages of more than 10 times the minimum wage, amongst other measures.
  • The oil and gas sector is at the centre stage of Petro’s proposal for a couple of reasons. First, Colombia is a net oil exporter and majority state-owned company Ecopetrol accounts for 12% of the country’s revenue. Increasing taxes on the sector in the current oil price environment is an effective way to raise budget revenues. Second, there is also an ideological argument. Petro campaigned for a sustainable transition of the Metals and Mining and Oil and Gas industries. For that purpose, he made a very controversial appointment with Irene Vélez as Minister of Mining and Energy: a philosopher and doctor in political geography, she has close to no experience in mining and energy. Following the announcement by the government of restriction on fracking and limitations on new concessions or permits for oil explorations, credit spreads of oil and gas issuers (including Ecopetrol) widened significantly.
  • I also met a large utility firm in Bogota, and they were not spared either by policy change. The government recently changed tariffs to Consumer Price Index (CPI) from Producer Price Index (PPI) and the previous government had already prevented the Foreign Exchange market pass through for transmission assets, which is a problem for utilities that had funded their assets with long-term USD bonds on the assumption that their revenues were USD-linked.

Traditional economic indicators have the advantage of being generally accurate as they use a comprehensive set of data. However, the disadvantage is that they come with a large time lag. You are told today, what has already happened few months ago. On the other hand, high-frequency indicators, while focused on smaller (and arguably less accurate) data sets, help us to get a sense of how the economy is currently doing.

The use of high-frequency indicators were very popular during the Covid pandemic as things were changing very quickly, however I think it is worth having a look at them again as we currently are in a very uncertain macroeconomic environment.

In this blog, I’ve attempted to put together some of the most popular high-frequency indicators which I will monitor going forward, in order to identify any signs of stress emerging in the US economy. All of them are publicly available and I’ve added the links to the data sources at the end of the blog.

I have grouped all indicators into 4 major groups: labour market, consumer behaviour, general economic activity and inflation.

1) The US labour market

The slide below shows three popular high-frequency indicators for the labour market. Starting from the left hand side, you have the “real time job postings” from Indeed. This is confirming the trend we have seen over the last few months: demand for workers, whilst slowing, remains exceptionally strong. This will likely continue to remain so for the rest of the year as the ASA staffing index is still marching higher. This index tracks weekly changes in temporary and contract employment. Many companies rely on temporary help before hiring additional permanent employees, so staffing indices tend to lead actual employment by three to six months. Additionally, on the right hand side, I have added a chart looking at Google searches for “unemployment benefit”. This potentially gives us a real time picture of people concerned about layoffs. So far the number remains extremely low, indicating little sign of stress in the labour market.

2) Consumer behaviour

Consumption is the largest component of US GDP, so it is always important to keep an eye on consumer behaviour and what people are doing with their money. Below are 4 high-frequency indicators which help us understand this. In particular, you can see how often people are travelling, going out to a restaurant or staying at a hotel. Overall it appears the economy is back to where it was pre-Covid and, despite higher prices, people are still spending. The chart on the bottom right is also very important as it shows overall nominal spending. Thanks to the strong labour market, nominal spending is holding-up well and if that continues while inflation keeps on trending lower, we are going to see a pick-up in real spending in the second half of this year. This will likely translate into increased GDP in real terms.

3) General economic activity

As stated above, high nominal spending in an environment of falling inflation will likely result in higher real spending and real growth. A pick up in real growth is also what we are seeing from the Atlanta Fed GDPNow and the OECD weekly GDP tracker. Both indices attempt to track economic activity in real time. After two consecutive quarters of negative growth, we now might start to see real GDP trending back into positive territory for the second half of this year.

4) Inflation

Last but not least, is inflation. The chart on the left-hand side shows the Cleveland Fed’s estimates for current CPI. They tend to be fairly accurate and give us a good real time indication of what CPI is doing. The problem with CPI though, is that it is impacted by some lagging indicators. The most notable one is rents, which represents approx. 40% of core CPI. Due to the way it is constructed, rent CPI is not a good reflection of where rent prices are today, rather it is a reflection of what rents were a few months ago. Rent inflation has already started to decline, but this is not yet reflected in CPI. On the other hand, Truflation (right-hand side chart), looks at more real time data and as a result it might give us a better picture of current inflation. Overall it appears inflation in the US is slowing, but very slowly. This is because inflation is moving from goods into services, which unfortunately are more sticky.  

The Fed is on a hiking path and certain things will likely start to break. The most rate sensitive parts of the economy e.g. the housing market, have already showed some clear signs of slowdown. However the economy overall is still holding up relatively well. This could change at some point, but traditional economic indicators won’t flag the potential areas of stress in a timely manner, while high-frequency indicators can.

In this blog we had a look at some of the most popular high-frequency indicators and so far they are confirming that the labour market remains relatively strong and people are still spending. Real growth will likely pick up in the second half of this year, while inflation will slowly trend lower. Going forward, it will prove sensible to keep an eye on these indicators, to see if things are starting to change and whether potential cracks are emerging.

Sources for the high-frequency indicators used in this blog:

Since the beginning of the year, a few primary market deals have again raised concern about the gradual weakening of bondholder protection in emerging market corporate bonds.

When it comes to bond documentation, the devil is in the details. Offering memorandums are often in excess of 500 pages – the ones with over a thousand pages are viewed with a healthy degree of caution by the bond community – and sometimes only a few sentences/words make bondholders’ protection weaker and hence may change the economics of an investment. While there is some standardisation in terms and conditions in the high yield world, investors still have to do their homework. Here’s why, in 3 recent examples:

  • Equity Clawback: An EMEA corporate was looking to issue its first index eligible bond in order to refinance its existing debt and provide incremental liquidity. As part of the research process, our analyst considered the detailed terms and conditions of the bond. They identified that the economics of the bond were negatively impacted by the inclusion of off-market equity claw language, whereby the issuer could redeem 35% of the bond at 101% in the event of a public IPO or private equity injection. In our experience, we believe that Par (or 100%) plus the coupon of the bond is the norm amongst other emerging market high yield issuers and this would offer investors materially better economic returns in the event of an equity raise by the company. Consequently, we raised the issue with both the company and the advisory banks and suggested that they amend the terms to better support investor interest in the initial capital raise and secondary trading of the bond.  The bond terms were subsequently amended to reflect our concerns and improves potential bond investor economics.
     
  • Debt Incurrence Test and Leverage Calculation: The contractual ability of a corporate to incur new debt based on a leverage (gross/net debt to EBITDA) metric. Sadly, a market trend has emerged that can flatter and/or create inconsistent leverage definitions. EBITDA is too often proposed being calculated on an IFRS 16 basis (which tends to increase EBITDA by adding back lease costs) while debt is calculated on a non-IFRS 16 basis (which tends to reduce debt by excluding lease liabilities). Therefore, leverage metrics tend to be lower and the issuer’s ability to incur more debt increases. We engaged on that topic too with the aforementioned corporate, suggesting consistency (IFRS 16 or no IFRS 16 on both numerator and denominator) but in this instance were unsuccessful in having the terms changed. This problem is also seen in Latin American deals where we continue to push issuers and advisory banks to propose a consistent leverage definition in both marketing materials and underlying bond documentation.
     
  • Change of Control (CoC): Bondholders’ right to put the bonds (read: require early repayment), usually at 101%, in the event of a change in ownership. A decade ago, most CoC clauses in bond documentation were standard in the emerging market high-yield segment: initial ownership dropped to below 50% (or any other level set) and the CoC clause was triggered. Then, advisory banks started to be creative with an additional feature: the credit rating downgrade. The new CoC clause would only be triggered if (1) ownership dropped below a certain threshold and (2) the issuer’s credit rating was downgraded by one notch within a certain period of time. One recent Latam new issue had no less than a double-notch downgrade requirement for the CoC clause to be triggered (in addition to a carve out of any CoC protection in the event ownership changes at the holdco level). We pushed back on this and the response was that it was already embedded in previous bonds so it was retained for consistency.

There are many more examples, e.g. early redemption structures or the inclusion/exclusion of FX losses in net income for the calculation of restricted payments (particularly important for emerging market bond issuers). Some areas of the market are much weaker than others. China high yield property developers have had appalling and deteriorating bond covenants for some time. Their very large, permitted investment carve-outs have enabled them to increase joint venture and associate’s investments – contributing to the lack of transparency about off-balance sheet items and cash leakage to unrestricted entities outside the restricted group (see chart). The debt incurrence ability of Chinese property developers has also been facilitated by the fact that (1) it is not based on a debt leverage metric and (2) the fixed charge coverage ratio (often EBITDA to interest) condition was getting increasingly aggressive (i.e., lower) over the years. Some property developers simply don’t have restricted payments, and others no debt incurrence conditions whatsoever (aka high-yield lite deals).

Source: M&G, Moody’s High-Yield Covenant Database, Oct 2021, Excludes high-yield lite bonds.

With China property now under immense stress and the rest of emerging market corporate bonds facing a lukewarm primary market at the start of 2022, perhaps this is a chance for the asset management industry to ensure – through engagement with issuers and advising banks – that covenants do not weaken further from here, and actually improve in some areas of the market. The more bond investors make their order conditional to bond document changes, the more likely terms and conditions will be amended to the benefit of bondholders.

This month has been an active one for new issuance in emerging markets, including a huge increase in ESG-labelled bond issuance. Sustainable, social and green bonds are being marketed actively by issuers and currently meet robust demand on the back of both inflows to emerging markets (EM) and the continuous development of ESG strategies.

Less common, sustainability-linked bonds (“SLBs”) have nevertheless continued to emerge as a credible, forward-looking way for investors to buy into an issuer’s ESG improvements. SLBs see their bond coupon subject to the issuer’s meeting a sustainability performance target: the coupon increases by X bps (in general 25 basis points) per annum if the issuer does not meet its target. We wrote last year about the need to look beneath the surface of sustainability-linked bonds before investing.

Since Brazil-based Suzano issued the first ever EM sustainability-linked bonds in September 2020, a couple of Brazilian issuers have also tapped the market. In line with Suzano, logistics business Simpar issued a SLB with a coupon step-up (25bps) based on greenhouse gas emission targets. Simpar is highly rated (AA) by one leading ESG external provider, so the SLB may be less susceptible to any accusation of greenwashing. Klabin, a pulp and paper company, issued a slightly different – and interesting – structure with three distinct coupon step-ups (totalling a 25bps increase) based on three distinct performance indicators (water consumption, waste use and the reintroduction of wild species into the ecosystem) to complement their existing green bond programme.

The paradox of SLBs is that investors may wish the issuer to fail to meet its sustainability targets to get a higher return on the bond. This may not be a politically correct question in a world in which all investors claim they have “ESG in their DNA”… yet it is a very relevant one when looking at the economics of SLBs. Using a trivial example, a 10-year sustainability-linked bond with a 5% coupon which trades at par (100) and yields 5% to maturity will see its bond price increase by about 2% after the coupon increases by 25bps, assuming investors still require a 5% yield compensation for the credit risk. Arguably, one would still make a profit if bond spreads widened by less than 25bps (i.e. the coupon step up).

To be part of the cynical – and rather bold – camp wishing an issuer not to meet its sustainability targets, one must make the assumption that credit risk is not (or is very little) influenced by the company’s key performance indicator (GHG emissions, water consumption, etc.) set in the sustainability-linked bond documentation. Said differently, in our 10-year bond example one must expect the 5% yield (in similar market conditions) to stay unchanged after the company’s failure to meet its sustainability targets (see scenario 1 below).

From a purely ethical standpoint – putting aside the economics of the investment – responsible investors may claim that profiting on the company missing the targets is simply owed compensation for the company not participating in the sustainable effort due. Some may also simply regret the lack of improvements as they care about the ESG outcomes of their investments.

A different approach – which is not incompatible with an ethical stance – is to think that failing to meet the targets might impact credit risk, and hence the yield required by investors. In a world in which regulation has become increasingly tight on environmental standards, any company taking climate change lightly is at the mercy of operational disruptions in the future and the risk of fines and lawsuits. Forward-looking credit research takes such factors into consideration and rating agencies now incorporate ESG factors more effectively. This is where SLBs become very interesting for investors: they incentivise companies to perform a necessary business transformation. If successful, investors hold the companies that have transformed appropriately within their business environment – a positive for alpha generation and a positive for risk management; if unsuccessful, investors get some compensation through the coupon step-up. In a “normal” bond, an issuer that does not engage in the transformation required may see its business suffering and its credit profile deteriorating, ultimately impacting credit spreads over time without getting a coupon step-up as mitigating compensation. Returning to our fictional SLB example, failing to meet the target may well result in credit spreads widening by more than 25bps over time (see scenario 2). And if it does not, it probably meant that the sustainability target was not relevant or material enough for the business risk – it then raises the question of how ambitious was the performance target.

On top of credit risk implications over time, an issuer failing to meet a sustainability target may also see bond technicals weakening through lower demand from ESG strategies, which may become unwilling to hold an issuer missing their sustainability targets. SLBs are a new market and only time will tell how asset managers react to a missed target but, based on the recent very large books for new SLB issues, it is fair to assume that many investors would be disappointed and/or that some forced-selling pressure would occur for those with strict sustainability mandates. In late 2020, a number of very large European asset managers decided to remove exposure to green bonds issued by State Bank of India after it was made public that the Indian bank would finance the Carmichael thermal coal mine in Australia. It’s hard to see State Bank of India coming to the market with a new green bond any time soon. Sustainability-linked bonds may well face a similar threat in the future if they don’t deliver on their targets. To those wishing for the worst, be careful what you wish for.

Last week saw the first ever issuance of a Sustainability-Linked Bond (SLB) from an emerging market issuer. Brazilian pulp & paper producer Suzano issued US$750 million of Jan-2031 bonds at a yield of 3.95%. The bond coupon (3.75%) is subject to a sustainability performance target and shall increase by 25bps per annum from July 2026, if the issuer does not meet its target in 2025. It is different to a green bond. Green bond proceeds have to be used for environmentally-friendly projects. Sustainability-linked bonds can see their proceeds used for general corporate purposes.

It is only the second time in bond history that a company has used such a structure. Last year, Italian energy company Enel issued the first ever bond featuring a coupon increase (also 25bps) in the event of not meeting a sustainability performance target.

Suzano’s official rationale for using a similar structure is to reduce greenhouse gas (GHG) emissions intensity as “a key strategy for the company to mitigate climate change and address the climate crisis”. The fact that a Brazilian company innovates on the sustainable front may have come as a surprise to many investors, after Brazil and its President Jair Bolsonaro were centre stage of global criticism last year when parts of the Brazilian Amazon forest were devastated by flames. Listening to Suzano’s Chief Financial Officer, it might well be another reason why they issued the bond: “The fires and deforestation are caused by criminals, and we want to make sure that everyone understands that Suzano has a completely different story.”

The company’s key performance indicator for GHG emission will be measured as tonnes of CO2 equivalent (tCO2e) per tonnes produced of paper and pulp, per year. The Sustainability Performance Target (SPT) is a reduction to or less than 0.190 tCO2e/tonne produced as measured by the average of years 2024 and 2025. As can be seen in the chart below, the company has set the baseline as their 2015 performance of 0.213 tCO2e/tonne produced. Reaching their target by 2025 would therefore correspond to a 11% reduction in GHG emission intensity since 2015.

However, looking behind the surface, the company reached 0.193 tCO2e/tonne produced in 2018, very near their 2025 target which all of a sudden looks considerably less ambitious. During the conference call to bond investors, the company claimed that 2018 was an exceptional year in terms of production (the denominator of the performance target ratio). But last year Suzano was already very close to the 2025 target with 0.200 tCO2e/tonne. Sceptics may also be worried that if the company falls short of the target, it would be incentivised to increase production (denominator) in order to meet objectives. Management reassured investors by saying the goal clearly was to improve efficiencies of processes and energy procurement (i.e. the numerator) rather than inflating production, the latter being demand driven.

Another source of disappointment came from the fact that the bond coupon was linked to the GHG emission intensity target only. A common pitfall in the green bond market has been to overlook a company’s overall ESG credentials, just because they issue a green or sustainability-linked bond. We think an issuer’s ESG profile prevails over an instrument’s E, S or G structure and we do not buy green bonds of environmentally-unfriendly issuers in our emerging market corporate ESG-dedicated fund. Why is GHG emission intensity more important to a pulp producer than water management or industrial waste? Suzano’s water stress credentials are good but its toxic emissions & waste intensities are fairly weak. An ambitious target would have included the latter.

Suzano said that GHG emissions remained the key material topic for stakeholders and that the ICMA Sustainability-Linked Bond Principles recommended to use KPIs that have at least three years of history, which wasn’t available for other KPIs although the company kept the door open to issuing new sustainability-linked bonds with different KPIs in the future.

We did not participate in the new sustainability-linked bond issue as pricing was not in line with our expectations and our views of the company’s credit profile (including ESG credentials) and sector. The investment grade bond priced at 3.95% with little to no new issue premium, perhaps as a result of strong demand from ESG funds (the book was said to be $7 billion for a $750 million bond). Whilst it is good practice to perform in-depth due-diligence and challenge management teams on new bond structures, we also need to give credit to Suzano who is one of two pulp and paper issuers to have a green gas emission target in the developing world: there are only 8 globally.

Last year was very eventful in emerging markets with its share of US tariffs/sanctions, regime changes in many countries, mass protests across the board and Carlos Ghosn escaping Japan to soon-to-default Lebanon on the very last day of the year! 2020 promises many geopolitical risks. We have compiled some of the key risks below for developing economies, including “the biggest crisis no one is talking about”. Brexit has been intentionally omitted.

Persian Gulf tensions: One knows geopolitical risk matters when a few unsophisticated drones can suspend 5% of global oil supply (or 50% of Saudi Arabia’s oil capacity) over one night. It happened in September 2019 and it reminded everyone not only how fragile the Persian Gulf status quo was but also the far-reaching impact any type of escalation could have for the rest of the world with crude oil up +15% the day following the drone attack. Whilst the strait of Hormuz crisis seems to have abated in the second half of 2019, Iran now faces parliamentary election in February 2020 in a context of a sharp economic recession (IMF predicts -9.5% GDP growth in 2020) after two years of unilateral sanctions from the US (since May 2018). Elections could well revive tensions this year and escalation in the Middle-East could have a significant impact on asset prices in the region as the risk premium remains relatively low in some stronger-rated countries such as Saudi Arabia, Qatar, Kuwait or the UAE. Some weaker countries like Bahrain or deteriorating credit stories like Oman are even more vulnerable. Finally, another source of concern is Iraq where public discontent is growing quickly on the back of government corruption allegation. Elections in 2020 are a possible scenario and Saudi Arabia’s influence in the country has increased in order to counter-balance Iran’s alleged control of some Iraqi Shia militias. The pro-Iranian demonstration at the American Embassy in Baghdad a couple of days ago, followed by the US killing of a top Iranian General in Iraq on 2nd Jan, are here to remind us that the US-Iran tensions are unlikely to vanish in 2020.

US-China trade war: This is one of the biggest risks for emerging markets whose economies continue to rely extensively on global trade. The main channel of contagion comes from weaker Chinese GDP in turn resulting in lower demand for commodities. For instance, Sub-Sahara Africa is China’s second-largest supplier of crude oil after the Middle-East and also provides metals. Since 2014, most countries in the region have seen a significant decline in trade with China after two decades of growth. The US-China trade war has obviously exacerbated the global trade problem and some Asian economies are now seeing falling supply-chain related exports due to the decline in China exports to the US. However, some developing countries have emerged as winners. Vietnam, Mexico, Malaysia and Thailand all have benefited from either a direct rise in exports due to diverted US demand from China and/or an indirect rise in exports related to the supply chain of China’s competitors. There is also hope for a sustainable deal between China and the US which would revive global growth in 2020 and beyond. In December, both parties agreed on the “phase one” deal with some reduced US tariffs in exchange of improved protection for US intellectual property and additional purchase of US products from China. Rather truce than a deal though. The trade war is likely here to stay.

Taiwan elections, Hong Kong, North Korea and South China Sea: The incumbent President Tsai (Democratic Progressive Party) is likely to be re-elected in the Taiwanese January 11th presidential elections. Her party benefited from stronger economic data in recent months thanks to the US-China trade war which redirected some manufacturing to the island. The Hong Kong protests have also helped the independence-leaning party to gain ground over rival and more China-friendly opposition party. In Hong Kong, the protests that started in June 2019 are due to continue in January as the pro-democracy protesters now have more political capital since the landslide victory at the Nov-19 local elections. The domestic issues, coupled with the US-China trade war, have had a sharp impact on economic activity and job losses. The Chinese authorities have so far been relatively quiet but that might change after the Taiwanese elections. Elsewhere in Asia, year-end 2019 had its share of geopolitical escalation. North Korea said that it was considering new missile testing, against the commitments taken to denuclearised the Korean Peninsula. Malaysia recently joined Vietnam and the Philippines in their tough stance against China’s claim that the whole South China Sea belongs to China. The South China Sea has long been contested by many parties due to its geostrategic importance (military, shipping lines, natural resources).

US election: Another key geopolitical risk as Trump has been the most unpredictable US President in recent decades and in particular when it comes to foreign policy. The new US sanctions and tariffs the world has experienced since he took office are numerous (EU steel & aluminium tariffs, NAFTA renegotiation, China tariffs, Russia – although initiated by Obama, Iran U-turn, withdrawal of the Paris Agreement, etc.). Under a different US personality, emerging economies might not face the same unpredictability of one of the largest trade partners in the world and perhaps not constantly worry about the US dollar being used as a foreign-policy weapon. However, countries like Russia, Turkey or Saudi Arabia have benefited a lot from Trump’s relatively benign stance towards them and a change in the US administration may become bad news. On the economic front, most investors expect equity markets to reprice in the case of a Democratic victory. This would result in the Fed easing and a weakening of the USD. Whilst supportive of EM FX in theory, a weaker US dollar may also reflect a weaker US economy which would both impact US demand for commodities and affect risk assets across the world. In this scenario, EM debt as a whole may not perform well. Expect more clarity in March/April when the Democrat candidate could be known.

Turkey – US sanction risk: Turkey’s purchase of the Russian S-400 missile defence system – together with the October military operation in Northern Syria – have increased significantly the risk of sanctions from the US Congress. These could come in the form of visa bans for officials and asset freezes for state-owned bank Halkbank (Iran-related sanctions). The US have also threatened to close down two military bases in South-eastern Turkey. It remains unclear whether the US are willing to also implement broader financial sanctions on the banking sector as a whole, similar to what they did with Russia after the annexation of Crimea. Given Turkey’s banking sector’s huge need for short-term external funding, the latter option would bring material disruption to the Turkish economy and as a result is less likely because an implosion of Turkey would not be good news for either the European Union (Syrian refugees agreement with Erdogan) or the US (Russia would likely increase its influence in the region). Policy mistakes are another key risk, such as an aggressive monetary and fiscal easing to achieve the government’s unrealistic 5% growth target for next year. Bond spreads in Turkey, whether sovereign or corporates, have rallied hard late 2019 and barely reflect either policy-making or US sanction risks. Asset prices leave little room for error in 2020.

Image: A quarter of the world’s population faces extremely high water stress

Water Stress – “The biggest crisis no one is talking about”: In August, this is how the World Resources Institute (WRI) – which focuses on climate, food, forests and other environmental and social issues since 1982 – described global water stress risk. The June-2019 Chennai water crisis was just an example of this, when tap water had stopped running in India’s fourth-largest city (8 million people) after two years of bad monsoon rainfall and also because rivers are polluted with sewage. Unlike the emotionally-driven climate activism from Greta Thunberg, global research organisation WRI published in August 2019 a research-backed Aqueduct Water Risk Atlas (cf. picture) which found that 17 countries accounting for a quarter of the world’s population were facing extremely high water stress with consequences “in the form of food insecurity, conflict and migration, and financial instability”. Developing economies are increasingly aware of water management because water scarcity / stress may act as a real impediment to social and economic growth if not properly managed by countries. There are other ESG factors that matter for growth but investors tend to focus on the geopolitics of oil, climate risk in general or deforestation. Too few investors are really looking at water stress as a structural risk of economic, political and social issues. The 2017-18 Cape Town or the 2019 Chennai water crisis are examples of water stress that constrained economic growth and brought social discontent. But water stress can also contribute to escalation of armed conflicts like in Yemen or Syria where the water crisis has been a critical factor.

India/Pakistan: India PM Modi’s new Indian Citizenship Law passed in December 2019 has incorporated religious criteria for refugees or communities seeking naturalisation. The law provides facilitated eligibility to become Indian citizenship to Hindu, Jain, Parsi, Sikh, Buddhist, and Christian minorities – but not Muslims – from Afghanistan, Pakistan and Bangladesh. Widely criticised, the new law has been the subject of mass protests across the country and in particular in majority-Muslim state territory Kashmir. Early 2019, the region again saw an Indo-Pakistan military standoff after a vehicle-borne suicide bomber killed over 40 Indian forces in February. On the economic front, Pakistan (credit rating B3/B-) is also under pressure after GDP fell sharply in 2019. The IMF programme requires aggressive fiscal and monetary targets which already have resulted in anti-government protests. Any escalation of geopolitical risk with India would not be welcome.

Russia/Ukraine: Will last year’s good news carry on in 2020? The conflict between Ukraine and Russia which started in 2014 after Russia annexed Ukraine’s Crimea peninsula – death toll of 13,000 to date – has considerably improved since the Paris Summit on 9th December. Presidents Putin and Zelenskiy agreed to fully implement an existing ceasefire and on 29th December a long-awaited prisoner exchange of 200 prisoners happened. Mid-December, after many months of negotiations Ukraine (through Naftogaz) finally signed a new gas transit contract with Russia (Gazprom). This should indirectly help Ukraine’s budget as Naftogaz is a state-owned entity. The IMF programme and reform agenda of new President Zelenskiy are other positive factors. But asset prices have largely priced in the positive trend with Caa1/B- rated Ukrainian sovereign bonds in USD trading as tight as just over 200 basis points for a 2021 maturity… and mid 400 bps for the 5-10yr part of the curve. Clearly the market is Putin a blind eye on any downside risk from geopolitics in Ukraine, rightly or wrongly.

Social unrest across the globe: It’s not a surprise to anyone when the French demonstrate with yellow vests or go on strike against the pension reform. However, the violent mass protests in Chile following a raise in Santiago’s subway fare took most investors by surprise in 2019. And last year saw an almost unprecedented series of protests against corruption, inequalities and long-standing regimes. In no particular order: Lebanon (PM resigned amid street protests), Sudan (President Omar al-Bashir was ousted after a coup d’état following mass protests), Algeria (President Bouteflika departed – he was in power for 20 years), Iraq (PM resigned), Bolivia (Morales resigned after protests), Puerto Rico (Governor stepped down), Iran (mass protests), Colombia (mass protests), Argentina (political change), Hong Kong, etc. The trend had started since the Global Financial Crisis but clearly accelerated in 2019 and whilst each protest has its own dynamics, to a certain degree they all shared the same claim for fundamental changes in the system they lived in. Have financial markets priced in the structural rise of populism that comes from public discontent? Surely there is more to come in 2020 and investors are not immune to new surprises like the Chilean protests.

Fully government-owned corporate bond issuers (or quasi sovereigns) are one of the most interesting areas of emerging market debt investing, due to the hybrid nature of their credit risk: partly corporate credit, partly sovereign risk. Venezuela’s national oil company PDVSA is an example of what can go wrong, as it is in default. Bond investors are therefore currently spending more time looking at Pemex and Eskom, in order to assess whether they could follow a similar path in the future.

As Mexico’s national oil company, Pemex is strategically important for the country. Oil revenues contribute to approximately 20% of Mexico’s budget and Pemex is one of the largest employers in the country. Due to a lack of investment in its upstream segment for years, oil production has been heading south at a significant pace; cash flows have suffered from the lower oil price since 2014 and a substantial tax rate (as the company is the cash cow of Mexico’s budget). Meanwhile, Pemex has continued to tap the bond markets to fund its sizeable and recurring cash burn (i.e. bond investors are effectively funding the Mexican budget through Pemex) due to the misleading “implicit guarantee” from the government. (The concept of implicit guarantees had been discussed in a previous blog here). Today, the company is facing refinancing risk as debt maturities pile up and investors have realised that the company is technically insolvent, with more than $100 billion of debt, enormous unfunded pension liabilities and a negative equity balance.

South-Africa’s Eskom runs more than 90% of the electricity market in the country. Rated BBB- in 2014, Eskom was investment grade a few years ago. However, given that the company underinvested and misallocated capital for a decade, it has come under huge financial stress in the past 4 years, as electricity demand stagnated and regulated tariffs increased at a lower pace than fixed costs. In addition, municipal arrears have soared and various corruption scandals at the top management level resulted in a lack of stable leadership for years (10 CEOs in 10 years). Throughout the period, financial costs increased materially and Eskom found itself generating just enough cash from operations to pay for its interest expenses. That meant all capex had to be funded inorganically. While the government provided cash injections for several years, the company also chose to incur debt. Eskom’s credit rating is now CCC+ and the company is said to be struggling to pay for coal procurement.

Two different countries, two different sectors but one common denominator: they are both fully-owned by their respective government and the above table shows the magnitude of the challenge for their respective countries. Both Pemex and Eskom are textbook examples of poor governance due to historical short-term political considerations that came at the expense of strategic investments which should have paid off well beyond any political mandates. Transparency is a critical element of governance. It holds management accountable and significantly reduces corruption risk. In my experience, emerging market fully government-owned corporate issuers in their vast majority have weaker transparency/disclosure than majority-owned and/or listed corporate bond issuers. But paradoxically, instead of taking this full ownership structure as a red flag, bond investors tend to discount the elevated governance risk with the lower probability of default, on the assumption that governments will always financially support their strategic assets. This is not a sensible way of investing in corporate assets. The fact that fully-owned quasi-sovereign bonds are part of the emerging market sovereign bond index (JP Morgan’s EMBI index), even when there are no sovereign guarantees, is not helpful and should be questioned. Any emerging market corporate asset analysis must encompass a sovereign risk assessment; if quasi-sovereigns were part of the corporate index they would be under much more scrutiny by corporate analysts.

Both Pemex’s and Eskom’s governments have recently come out with sovereign support packages which certainly will reassure investors (albeit to varying degrees) and reinforce their views that both companies are sovereign investments and hence face sovereign-like default risk. However, to date, the actual details of state support are disappointing and unlikely to move the needle. Along with sovereign support, improving transparency and governance might be key to restore investors’ confidence over time. But how do you do that? It is unlikely to come from a new government – we have all heard that story before. One of the most credible options is to partially list parts of their businesses to force those companies to adopt financial market reporting requirements and generally-admitted sound business practices. Eskom and Pemex are both strategic assets and it is understandable that the people of South Africa and Mexico want to retain their control, but it would take just a small publicly listed ownership to make these changes happen. Brazil’s national oil company Petrobras is publicly listed and majority-owned by the government of Brazil and is a good example of a transformational turnaround when a government accepts to partially step back on business strategy. Listing not only brings transparency, but also attracts private expertise that may bring checks and balances to political considerations, i.e. exactly what Pemex and Eskom have been missing for years, if not decades. Partial privatisation will make their bonds fall out of the sovereign index (expect forced selling pressure in this case) into the corporate universe and over time, would receive the necessary bond investor due diligence that they deserve. There is no perfect fix, but the short-term political cost of partial privatisation is likely to be more than offset over time by savings on sovereign support to poorly-run businesses.

The current political rhetoric in Mexico however makes any sort of partial privatisation unrealistic in the near term. Pemex roughly pays over 40% of revenues and 85% of EBITDA in tax and royalties, so an easy fix for the government would be to reduce tax to a “normal” level. In this way, the company could generate enough cash to organically fund its investment needs upstream, in order to revive production. But from a sovereign perspective, this may prove challenging as Pemex contributes to 9% of Mexico’s budget revenues, so the government would need to source revenue elsewhere. Tax collection is very low in Mexico and under President Lopez Obrador, new tax increases and spending cuts are unlikely. In the event that the Pemex situation doesn’t get fixed quickly, we estimate that Pemex’s cash burn will cost Mexico 1% of GDP per annum. Should Pemex not have access to debt markets for refinancing, the bill will go up to 1.7%. At this stage, Pemex may contemplate issuing fully and unconditional sovereign guaranteed bonds.

Eskom’s situation is arguably worse. Whilst its debt levels account for “only” 7.8% of GDP vs 10.8% for Pemex, Eskom’s underlying cash flow generation is deeply negative and cannot be fixed by a tax cut from the government or issuance of additional sovereign guarantees. A capital injection is therefore needed to operate as a going concern. The recently announced breaking down of the electricity sector with a separate transmission business might open the door to privatisation in the future and is a good step forward – definitely more credible than the Pemex support plan. However, the upcoming general elections will be a big challenge in order to implement any meaningful reforms in the short term. The total bill for South Africa may come at 1.6% of GDP p.a. in the next few years.

The Pemex and Eskom cases are today’s problem, but they offer great lessons for predicting tomorrow’s potential credit deterioration of emerging market fully-owned quasi-sovereigns. With that in mind, red flags exist in China where highly-rated state-owned enterprise issuers require a cautious approach by investors, as it often starts with weak transparency.

To read more on Quasi-Sovereigns in Emerging Markets, see our panoramic.

Few investors would have bet on emerging market (“EM”) corporate bonds fifteen years ago. In 2004 the EM external (also known as hard-currency) corporate bond universe was relatively small at approximately US$ 270bn. By 2009 the asset class had more than doubled to US$ 600bn driven by strong economic expansion across developing economies notably the BRIC countries. Since the global financial crisis, emerging market corporate bonds have experienced the strongest growth across fixed income markets (Figure 1.) with the size of the external EM corporate bond universe increasing to US$ 2.2 trillion by the end of last year.

The rise of EM corporate bonds has resulted in it becoming a standalone asset class (Figure 2.) and therefore a new area of focus for global credit investors. For instance, EM high-yield bonds now account for 23% of global high yield investment opportunities compared to just 8% in 2009; I’m confident that the share of EM in global indices is going to continue to increase over the medium term. The much larger EM corporate bond universe in local currency has also posted impressive growth (+300% since 2009) and is approaching US$ 8 trillion in size, comparable to the EM local sovereign bonds and larger than the US investment grade market. Yet, the “investable” part of this market remains small for global investors.

This outlook explores the three segments that are worth watching over the next few years: the mature EM external corporate bond universe, its fast-growing high yield segment, and the enormous but illiquid EM local corporate bond market.

Figure 1 (left). Figure 2 (right).

Emerging Market External Corporate Bonds: The Established Market.

The impressive growth of US dollar denominated EM corporate bonds in the past decade (Figure 3.) has been a long time coming, especially given the small size of EM fixed income markets compared to their contribution to world GDP (over 50%). Issuance in US dollar, and other hard currencies, was the result of three distinct factors. Firstly, some EM issuers operate in “dollarized” sectors (e.g. commodities) or countries with pegged currencies, like UAE, hence naturally preferring to borrow in a currency that doesn’t create an FX mismatch on their balance sheet. Secondly, funding needs for investment increased in line with EM economic expansion but local debt markets (bank loans and bond market in local currency) lacked depth. Long-term and sizeable debt financing for large corporates – such as utilities – in general were not available locally. EM issuers therefore started to look at international bond markets. Thirdly, market technicals improved as demand from global bond investors emerged, in addition to dedicated EMD managers, due to diversification benefits after the global financial crisis hit many portfolios.

Figure 3. (left) / Figure 4. (right)

From a credit standpoint, bond stock growth has been driven by investment grade (IG) and high yield (HY) issuances equally. Nevertheless, the split still favours IG credits. As of January 2019 HY credit represented 36% of the bond stock (43% for JP Morgan’s CEMBI BD index). Quasi-sovereign issuers account for approximately half of the universe and are now worth just above US$ 1 trillion – a similar size to EM sovereign bonds in hard currency. For more information on Quasi-Sovereign bonds you can read this blog: https://bondvigilantes.com/blog/panoramic-outlook/quasi-sovereigns-in-emerging-markets/

One remarkable trend in the asset class has been the material increase in Asian bonds as a share of the universe (Figure 4.) driven by enormous issuance from China in the past 10 years. Excluding Asia the asset class shows more modest growth since 2011 (+83%) and is only marginally up from 2014 (+6%). Asia external corporate, including quasi, bonds were worth US$ 1.1 trillion at year-end 2018 – which is bigger than the whole EM external sovereign bond universe – and 51% of the total EM external corporate bond asset class. This is in strong contrast with Asia being only a small share of EM external sovereign bond stock. With its US$ 650 billion external corporate bond market China represents 30% of the asset class (although capped at 8.1% in the CEMBI BD index) and is the largest economy among the 50 countries in the EM index. Mexico (8.8% of total bond stock), Brazil, Korea, Russia, Hong Kong, UAE and India are also large country contributors. Thanks to these diverse geographies only net negative supply from China would alter the size of the asset class.

In terms of sectors, as measured by the CEMBI BD index – Figure 5., the impressive growth of Asia has had little impact on the diversity of the asset class. Financials remain one-third of the index and unlike developed market financials are less exposed to contagion risk (e.g. Colombian banks are unlikely to be impacted by a banking crisis in Indonesia) although China’s financial institutions are systemically important for Asia. Commodities account for about 20% (Oil & Gas 14%, Metals & Mining 7%), usually smaller than what most investors would expect from an EM debtor. TMT and Utilities are also large sectors and in line with the economic expansion, the Consumer sector (9%) has been growing at a faster pace than Industrial sectors.

Figure 5. (left) Sectors / Figure 6. (right) Returns vs Vol

Looking at performance (Figure 6.), EM external corporate bonds have generated decent returns in their relatively short history. Since 2004, last year’s total return of -1.65% (JP Morgan CEMBI BD index) was only the third year with negative returns (after 2008: -16.8% and 2013: -1.3%) whilst the cumulative return during the period (2004 to Oct 2018) was 145%. The index’ annualised total return was 6.1% whilst annualised volatility stood at 7.9%. For an asset class that has an average credit rating of BBB-, returns look higher than developed-market counterparts but so does volatility. The asset class’s Sharpe Ratio of 0.6 appears average, if not better, compared to other asset classes during the same period (2004 to October 2018) but lower than EM sovereign external debt (0.7), US HY (0.7) or US IG (0.7).

Emerging Market High Yield Bonds: Size Matters.

The substantial increase in EM external corporate bonds has had implications for other asset classes, notably Global High Yield. Historically, emerging market corporates have been a small allocation in global high yield investment mandates where many primarily focus on the US market followed by the European high yield bond market. In 2009 investors justified the smaller allocation to EM by the 8% weight in the index (Figure 7.). In 2015 EM HY surpassed in size European HY in the index due to two main reasons. Firstly, EM high yield issuance increased significantly between 2009 and 2015, in line with the rest of the EM external bond market. Secondly, a lot of existing EM bonds were downgraded to high yield after many sovereign issuers lost their investment grade status (e.g. Brazil, Russia) in the aftermath of the Taper Tantrum. As such, new issuers, like Brazil’s national oil company Petrobras or Turkish banks, appeared in the global high yield index.

Figure 7 (left) / Figure 8 (right)

Today, EM HY bonds represent 23% of the BofAML’s Global High Yield index and the outlook points to an increasing share of EM going forward. Another interesting element is the index composition which demonstrates that emerging markets are not small weights in the index. Emerging market issuers account for 20% of the market value of the top 150 issuers (representing 47% of the global high yield index) Furthermore, Petrobras and Israel-based pharmaceutical company Teva are respectively the first (2.1%) and fifth (1.2%) largest issuers in the index.

Surprisingly, US investors nevertheless still avoid EM with an estimated holding of 2.2% of EM HY bonds in US high yield portfolios. But this does not seem to be driven by valuations, since the range of EM HY holding has fluctuated between just 2% and 4% since 2011. The underweight stance is rather explained by geographic and sector bias of US and European high yield managers. This tends to be confirmed by significant holdings either in countries that are geographically close to the country of origin (e.g. Mexico) or in sectors that have global reach (e.g. commodities, TMT) and for which non-EM high yield analysts and portfolio managers feel more comfortable. The perceived lower credit quality and additional top-down approach required to analyse EM corporate bonds are also factors that could explain why the asset class remains under-represented.

Yet, EM HY default risk (Figure 9.) and recovery values look no worse than their US and European counterparts. You can read more here: https://bondvigilantes.com/blog/panoramic-outlook/emerging-market-corporate-bonds/ On the returns front, the trend since 2008 suggest that US and EM HY returns can be very diverse (Figure 8.). As the size of EM HY continues its march higher, asset allocation within global high yield bond funds is likely to become a much more important driver of future performance.

Figure 9.

Emerging Market Corporate Bonds in Local Currency: the niche market.

It may be surprising to developed market investors but the size of the emerging market local currency bond universe (sovereigns + corporates) is almost 5 times larger than the external bond market (Figure 10.). But as ever in emerging markets, don’t be fooled by appearances. The fastest-growing market has been the local-currency corporate bond market which now totals approximately US$ 7.8 trillion equivalent – that compares with US$ 2.2 trillion of EM external corporate bonds. Yet, local corporate markets remain niche because of two main drivers: currency risk and thin liquidity.

There are two types of EM local-currency corporate bonds: local and global local bonds.

Local local corporate bonds are bonds issued locally subject to local taxation and regulatory rules, which require domestic custodian accounts. They account for more than 90% of the EM local corporate bond universe with half being onshore Chinese debt. Local bonds appeal most to domestic investors because they don’t have to take the currency risk. The bonds in general also tend to offer a yield pick-up over local sovereign bonds and knowledgeable local participants (brokers, traders, investors, analysts) help navigate the market. Foreign investors conversely may find it difficult to invest because of taxation, currency risk, thin liquidity and limited availability of information outside of the country.

Figure 10.

Global local corporate bonds are local bonds that settle through Euroclear where investors don’t require local accounts and in general are tax-free bonds. They account for less than 10% of the local corporate bonds. This market also includes dual-currency bonds which are local bonds that settle in a different currency (often US dollar). They are often coined with peculiar names, e.g. masala bonds in India or komodo bonds in Indonesia. Foreign credit investors usually favour this market because it removes the tax burden. Liquidity nevertheless remains a big hurdle. Roughly half of euro-clearable bonds are not index eligible  mainly because of the lack of liquidity (no active pricing or bond size filter). Taking BofAML’s LCCD index as a proxy for the most liquid names, the “investable” global local bond universe stood at just US$ 245 billion. This is only a fraction of the optically huge US$ 7,800 billion local EM corporate bond stock and arguably most index bonds will see some liquidity only in small size (i.e. below $1 million equivalent) in sharp contrast to much better liquidity elsewhere in EM debt. Foreign investors also remain exposed to currency risk. Analysis of the index shows that the volatility of the asset class is nearest to EM local-currency sovereign bonds and furthest to EM external corporate bonds. This means that the currency risk – as opposed to corporate credit risk – is one of the primary drivers of volatility whilst liquidity is poorer than the very liquid EM local-currency sovereign bond universe. Furthermore, the lack of country, and currency, diversification may not be suitable to all portfolios. China, Mexico, South Africa, Russia, Malaysia, India, Colombia and Singapore accounted for 85% of BofAML’s LCCD index as of 15 January 2019. As a final point of note, the lack of index research and coverage by rating agencies (28% of the index is not rated) may be additional barriers for foreign investors who may favour the more diversified and liquid external corporate bond market.

Author: Charles de Quinsonas

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