A safer option for future investment

Emerging markets used to be synonymous with volatility, instability and nasty surprises. Crises in the developed world invariably affected investor sentiment towards emerging economies, often acutely. And problems in the regions themselves would always trigger immense crises of confidence among international investors.

But times have changed. "There is much less of a knee-jerk, generic response to crises. When the Dubai situation erupted, it was difficult on day one but by day three, things had stabilised. When Mexico hit problems, it took three months for emerging markets to stabilise and with Russia, it was six months," says Jonathan Brown, head of global emerging market syndicate at Barclays Capital.

The shift in behaviour patterns reflects several distinct but related factors: inherent developments within emerging economies, trends in banking and capital markets, interest rate movements and institutional attitudes towards investment.

Stable option

"Emerging markets have more dynamic economies than the developed world: they have huge growth prospects, they did not experience the credit crunch and their companies will, in many cases, be a better risk than developed world corporates over the next five years," explains Jerome Booth, head of research at Ashmore Investment Management.

While most are growing at a faster rate than those in the developed world, borrowers in those regions are paying more than equivalent credits in mature markets.

"An 'A' rated emerging market corporate is paying about 5.125% for a five-year paper. An 'A' rated US industrial is paying just over 3% for the same maturity. That means investors are getting more than 200 basis points for emerging market credits. At a time when the search for yield is acute, this is a highly attractive scenario," explains David Spegel, global head of emerging market strategy at ING. So tempting that, in 2009, $220bn of bonds were issued by emerging market borrowers. Within that figure, $90bn related to sovereigns and the remaining $130bn to corporates.

"Last year was a record one for new issuance. The first half was dominated by sovereigns, but corporates began to enter the market in the second half and investor appetite really developed," adds Mr Spegel.

Unsurprisingly, volume in 2009 was more than twice the $96bn of issuance in 2008, which was a desperate year for capital markets globally, but it was also 36% higher than the $161bn of total emerging market issuance in 2007.

"People are quite excited about emerging markets in this climate. There is so much potential, particularly in the BRIC [Brazil, Russia, India and China] economies and certainly at the quality end of the spectrum," explains Martin Egan, global head of syndicate at BNP Paribas.

Supply and demand

That excitement began to gain momentum five years ago, as financial markets blossomed, risk appetite grew and the commodities boom fuelled emerging markets' growth.

"Things really started to take off in 2005/06. And by 2007, only 15% of emerging market issuance was sovereign; the rest was corporate, including a lot of high-yield," says Julian Jacobson, director at FPP Asset Management.

In 2008, as the financial crisis exploded, emerging market issuance dried up but performance through the credit crunch was less disastrous than many feared. "Over the past two years, emerging markets have proved relatively resilient. Compared to developed world high-yield, property and equities, returns have been robust," says Mr Brown.

This realisation contributed to soaring supply and surging demand in the emerging market - a situation that began in the late spring and gained momentum over the subsequent six months. Issuance grew, spreads contracted and the mood was rather upbeat.

Then came Dubai World's debt standstill request last November. Ultimately, of course, this prompted a $10bn bailout from Abu Dhabi, but not before investors' faith had been severely shaken by the realisation that state support for Dubai credits was far from axiomatic. As a result of this, people are becoming a lot choosier about where they will invest.

"Name lending, personal guarantees and supposed implicit state guarantees were part of the investment decision process," says Giambattista Atzeni, Middle East and north Africa business manager for corporate trust at BNY Mellon. "From now on we can expect a more thorough due diligence, increased disclosure and greater transparency. These are positive signs of a maturing market."

For many investors, the Dubai World drama highlighted the need for greater credit analysis, not just in Dubai but across the Middle East and beyond. Paul Reynolds, head of Middle East debt and equity advisory at Rothschild, believes that emerging regions need to be incentivised to build deeper and more liquid markets. Moreover, regulatory infrastructure needs to be improved, insolvency regimes enhanced and many investors need educating.

"A number of asset managers will not invest in the Middle East, for example, because they don't understand what happens in a credit default situation. Others will buy but at a price - so the cost of capital is higher than it needs to be," says Mr Reynolds.

The cost of capital is a thorny issue, particularly for less well-known credits. By the fourth quarter of 2009, investors were showing interest in speculative grade emerging market paper but borrowers were reluctant to pay the rates institutions demanded.

"On a five-year maturity, for instance, a single B emerging corporate would have to pay around 9.4%, while a B- credit would be looking at 10% minimum. Russian corporates in particular find these levels deeply offputting, especially as they are able to fund themselves through the domestic banking market," says Mr Spegel.

But such local funding is almost bound to become less accessible as state support is gradually withdrawn from domestic banks in the Commonwealth of Independent States (CIS) region. And this reflects a wider phenomenon affecting emerging markets as much as those in the developed world: borrowers need access to debt, and if they cannot get it from the loan markets, they will be forced to go to the capital markets.

Liquid assets

Most bankers and investors believe issuance in 2010 will be close to 2009 levels, but the type of issuer may well change. According to Mr Spegel, in the last quarter of 2009 there were as many ratings upgrades as downgrades, while in January of this year, upgrades exceeded downgrades in emerging market credits. This has prompted increased interest in general and in speculative grade paper.

In the first half of 2009, only $2bn of corporate high-yield paper was issued by emerging market credits. This quadrupled to $8.5bn in the third quarter; then doubled to $19bn in the fourth. Many believe that upward trend is set to continue this year, albeit at a less dramatic pace.

"Last year, maturities outweighed new issuance by $20bn so investors were left with net cash, which they have to put somewhere. They cannot just leave it on deposit," says Mr Spegel. Nonetheless, there is a widespread belief that investors are more discriminating than they were before the credit crisis. Perceived liquidity is very important: investors got very scared in 2008 when they could not get out of positions.

"They are more confident now but they demand higher returns than in the past," says FPP's Mr Jacobson. "Last year, there was a huge preference for liquid issues. This may change slightly in 2010, but investors are still not as gung-ho as they were pre-crisis, nor are they likely to be for a very long time - which is a good thing."

Last year, regions such as Asia and Latin America were most in demand, responsible for almost 60% of emerging market issuance between them. Emerging Europe - including Bulgaria, Romania, Poland, Hungary and the Czech Republic - accounted for 16% and the Middle East for a further 12%. Africa issued a tiny 3% of total issuance while the CIS - effectively Russia, Ukraine and Kazakhstan - issued 10% of the total.

In 2010, CIS issuance - at least from Russia - is expected to rise. Borrowers will almost certainly need to turn to international markets as local bank credit becomes more difficult to access. And investors are prepared to purchase Russian paper, but they are likely to continue demanding high yields, at least in part to compensate for the relative lack of regulatory infrastructure or bankruptcy legislation.

Martin Egan, global head of syndicate at BNP Paribas

High price

Similar patterns are expected in the Middle East, where a large proportion of paper - $17bn out of $156bn outstanding - is completely unrated. In other words, demand from issuers is there but the price they will have to pay is high.

Across the emerging markets universe, however, there is a growing awareness that underlying dynamics are shifting. Many credits are less well-known and not as well rated their developed world counterparts; regulatory and legislative systems are less developed and reporting is less transparent but - and it is a big but - economies are growing fast and are far less constrained by the credit crunch than Europe or the US.

Situations such as Greece serve to highlight that the distinction between 'emerging' and 'emerged' may indeed be blurring. It has a higher sovereign default rate than almost any emerging economy and some investors are beginning to feel that certain emerging market credits are actually safer than high-risk sovereigns in the West.

"We could see a redefinition of emerging markets," says BNPP's Mr Egan.

Such a shift, should it occur, may well take several years. Despite that, during 2010, demand is expected to persist for emerging market names, particularly corporates offering a decent yield and an understanding of investors' need for a degree of financial transparency. Last year, it was virtually impossible not to make money in this market. This year, the trend is expected to be more volatile.

"By definition, there will be surprises, such as Dubai last year," says Barclays Capital's Mr Brown. "But the markets can and will cope with such situations. Last year, spreads tightened considerably. Now they are likely to stabilise overall, but there will be volatility in the short term."