High Anxiety Over Emerging Market Corporate Debt
Institutional Investor, Oct 22, 2015
Emerging-markets debt has reached worrying levels again, but the focus of anxiety is different than it was during the crises of the 1980s and ’90s. Sovereign states have largely heeded the lessons learned from those debacles. Much unlike their developed-world peers, they’ve held debt steady since 2000, at about 40 percent of gross domestic product, according to the Institute of International Finance in Washington.
Emerging-markets corporations, by contrast, have boosted leverage rapidly, bolstered by the improved ratings of their sovereigns and a torrent of global capital seeking yield in the low-interest post-2008 environment. Corporate bond issuance from developing countries has nearly doubled since the onset of the Great Recession, to $6.8 trillion, the IIF reports in a June research note. Some $2.6 trillion of that total represents direct borrowing by nonfinancial corporations, which is considered riskier than borrowing by regulated banks. The proportion of debt denominated in U.S. dollars has also increased swiftly, to as much as 30 percent.
That makes for a daunting prospect with emerging-markets corporate profits falling, economic growth and commodity prices running at lower levels, and local currencies sliding against the greenback. Nonfinancial firms in the developing world need to pay back some $375 billion in hard currency loans from 2016 to 2018, the IIF found. No wonder emerging-markets corporate bonds have sold off 7 percent since late May, as measured by the iShares Emerging Markets Corporate Bond exchange-traded fund.
“This could end up being a very difficult period,” says Jamie Stuttard, head of European credit strategy at HSBC Holdings in London. “The past few years, when debt from the likes of Brazil and Russia entered mainstream portfolios, may turn out to be an aberration.”
But other investors question whether the outlook is dire enough to turn their back on bonds paying 5.5 percent coupon interest on average, to judge by the iShares ETF portfolio. IIF executive managing director Hung Tran, who led the institute’s recent research, expects a steady drizzle of defaults rather than a tsunami in emerging-markets corporate debt. “This will be a slow, protracted difficult situation, not a crisis,” he says.
Although the raw debt numbers have ballooned, relatively little of that growth has come from the most vulnerable countries — like Brazil, Russia or Turkey — or sectors most likely to be caught with currency mismatches, such as construction and retail. Mainland China and Hong Kong have been the chief revelers at the new debt orgy. Both now carry nonfinancial corporate IOUs well in excess of annual GDP, according to IIF data. The comparable ratio for Turkey and Brazil is about 50 percent. China, for all its well-noted recent problems, remains a fast-growing economy with abundant sovereign reserves that could be tapped before prominent corporates were allowed to go bust. “China has not quite moved yet to a free market system of defaults and default probabilities,” Stuttard says.
On a sector basis, nearly half of all nonfinancial emerging-markets bonds are issued by energy and commodities producers. Although these companies’ revenues suffer as prices for their wares decline, many are also cutting costs, which they pay in depreciating local currency.
That natural hedge makes for pockets of value in the debt of raw materials giants like Brazilian miner Vale, whose 30-year bonds maturing in 2042 are trading at 88 cents on the dollar, for a yield of 6.57 percent, says Pierre-Yves Bareau, London-based head of emerging-markets debt at J.P. Morgan Asset Management. “A lot of people have gone very underweight emerging markets, which leads to value in the commodity space across Latin America and in Russia too.”
Emerging-markets corporate debt as an asset class remains much safer than U.S. junk bonds, with which it often competes for investor dollars. Two thirds of all emerging-markets corporate debt remains investment-grade, according to Credit Suisse Group, despite a recent downgrade by Standard & Poor’s for one of the biggest debtors, Petróleo Brasileiro, from BBB– to junk status BB. Junk credit offsets risk by paying 1 percentage point more average interest, according to the portfolio held by the iShares iBoxx $ High Yield Corporate Bond ETF.
That’s not to say that emerging-markets corporate debt will become a source of easy returns again. The IIF counts 15 economic sectors around the world with debt that exceeds five times earnings before interest, taxes, depreciation and amortization. Groups like South Korean industrials, owing 11.3 times ebitda, or Turkish energy, with a ratio of 8.7, seem in over their heads. Nor should lenders to greater China assume anymore that Beijing will step in to cover all debts, the IIF’s Tran cautions. Chinese corporates have racked up $14 trillion in debt, swamping the country’s $3.2 trillion in sovereign reserves.
Still, investors who keep cool and do their homework may find some gems in the prevailing gloom.