Emerging market credits have enjoyed a financing renaissance in the international bond and loan markets in the past two years. However, the shadow of rising US interest rates and oil prices is casting a pall over emerging market bond issuance. By Joanna Hickey.

In the aftermath of Russia’s 1998 financial crisis, Brazil’s 1999 devaluation and Asia’s restructuring, the international bond and loan markets were closed for many emerging market (EM) issuers. But by late 2002, the financing tide turned back in their favour. With plunging global interest rates and a shortage of high yielding paper due to a dearth of M&A activity, investors embarked on a global hunt for yield. Coupled with improving fundamentals in most EM countries, this meant that, despite their chequered recent history, EM issuers were enjoying broad access to international financing at very attractive rates by 2003.

“Investors have historically forgiven easily and forgotten quickly. In the falling interest rate environment of the past two years, investors looked to the emerging markets in their search for incremental yield,” says Carlyle Peake, head of emerging markets syndicate at Dresdner Kleinwort Wasserstein (DrKW).

Inflows of capital into emerging markets increased. As well as traditional investors, new hedge funds were established to invest in the asset class and pension funds entered the market. “By the end of 2002, bond investor liquidity for emerging markets was extremely strong. Pension funds started buying EM bonds for the first time, helping to further swell market liquidity,” says Loic Cadiou, global fixed income investment manager at Credit Agricole Asset Management (CAAM).

According to Atiq Ur Rehman, global head of emerging market debt at Citigroup, loan market liquidity also soared. “Loan market appetite for emerging markets credits has been robust since 2002. Bank liquidity for the asset class definitely now exceeds pre-1998 levels,” he says.

And as liquidity swelled, the market opened up to new types of financing: the mix of products expanded and new markets opened up to bonds, such as areas like eastern Europe. “Globally, we are now seeing clean unsecured loans for corporates, as well as more trade-backed and receivables-backed financings and structured financings,” says Mr Rehman.

Whereas previously the international financing markets for EM credits were the domain of sovereigns, banks and top corporates – which often required government support to borrow – the issuer base has diversified hugely. “There is now a far broader range of EM borrowers. In the last two years, a whole range of EM corporates have issued bonds,” says Mr Rehman.

More financing activity has emanated from central and eastern Europe and Latin America than from Asia. Although Asia’s international bond and loan volumes have also risen, highly liquid domestic markets mean that issuers can raise cheaper funds locally. As a result, Asian corporates issue twice as much paper in their local currency bond markets as in the international bond market.

Pricing plummets

Strong investor liquidity has not only boosted deal volumes, but has also caused both bond and loan pricing to plummet. The technicals-driven bond market has suffered the most dramatic pricing erosion, with spreads on JP Morgan’s Emerging Market Bond Index (EMBI) plunging from 1041bp in September 2002 to 384bp by January 2004.

Competition among banks for EM bond mandates has also sparked an alarmingly rapid free-fall in fees. “The compression of fees in the last two years has been staggering.

In January, Brazil and Turkey both printed 30-year bond deals with fees at just 0.30%. With investment grade bond fees at 0.875%, it shows how competitive the market has become,” says Mr Peake.

Loan pricing across the global emerging markets has also taken a nosedive on the back of improving fundamentals and a positive credit environment in most countries.

“Banks are looking to build relationships with emerging economies and market sentiment is positive, backed by improving fundamentals especially for countries such as Russia (also helped by higher oil prices) and South Korea (due to the country’s high forex reserves),” says Zafar Alam, global head of emerging market debt at ABN AMRO.

Brazil and Russia have had the most compelling improvement stories in the past two years, with particularly rapid bond and loan pricing erosion.

Due to political uncertainty surrounding the election of Luiz Ignacio Lula da Silva to the presidency, Brazil’s EMBI index recorded a stratospheric leap to 2443bp in September 2002. However, his ensuing fiscal restraint combined with the overall growth in investor liquidity to send the index plunging to 399bp by January 2004.

In Russia, high oil prices have helped to increase banks’ risk appetite dramatically. The country’s oil and gas companies have been especially prolific loan borrowers in the past two years, while the top Russian banks are also accessing the loan market on increasingly attractive terms.

Not only is pricing falling, but also loan maturities are being extended to five years. Market sentiment has improved so much that banks are starting to forgo their receivables security for selected corporates. For example, whereas Gazprom would have paid about 400bp over Libor for a secured loan two years ago, in June it obtained a $300m unsecured three-year loan at just 275bp.

Tide turns for bonds

Many expected EM issuers to enjoy their patch of good fortune in financing until a full equity market and M&A recovery diverted institutional investors’ attention elsewhere. However, since April this year, bond market dynamics have changed dramatically once again for EM issuers – especially for the lower sub-investment grade credits. The shift in market dynamics is reflected in the JP Morgan EMBI, which rose from its low of 384bp in January to 572bp in May, to hover in the low 500bps by June.

Although many EM countries have internal issues – including speculation about a potential Yukos bankruptcy in Russia, China’s interest rates and political problems in Turkey and Brazil – this sudden deterioration in EM bonds is more attributable to two external factors: investors are concerned about the impact of rising oil prices on the economies in countries such as India and China; and they are increasingly worried about the forthcoming US Federal Reserve (Fed) interest rate hikes to combat inflation.

Bond investors are not only reluctant to buy EM paper that could shortly look under-priced, but are also particularly afraid that a slowing global economy caused by rising US rates will hit the more vulnerable emerging economies hard.

Risk aversion spreads

As a result, investor risk aversion has spread in the past three months. EM bond and equity sell-offs increased after April as investors sought to reduce their exposure. With a near-dearth of non-investment grade EM issuers accessing the new issue market since Gazprom in April, the immediate outlook for EM bond issuance is challenging.

“While leverage on new issue pricing was with issuers in January, it has now flipped to investors. Investors have become more defensive and their willingness to absorb risk at any level is much lower. They are much more particular about when they enter the market and which names they support,” says DrKW’s Mr Peake.

The bond markets are not shut for EM issuers – especially for the best rated credits – and by late June, some optimistic analysts felt that, with oil prices stabilising, investors were starting to feel more secure. However, most analysts say that investor nervousness remains and that most issuers will sit on the sidelines for the next few months until the outlook becomes clearer. Only the top issuers with the strongest track records are likely to brave the market.

For EM investors and issuers alike, everything now hinges on the Fed and how far and fast it puts up interest rates this year, following the first 0.25% rise on June 30 to 1.25%. Another 25bp rise is expected in August with the potential for further hikes later in the year.

“Everything hinges on the speed and extent of the Fed rate hikes. If they are gradual and small, the sell-off will stop and conditions will improve. But if they are quick and steep, the market could be closed to emerging issuers until at least next year,” says CAAM’s Mr Cadiou.

Expectations are mixed

Many bankers do not expect a repeat of the drastic hikes that took place in 1994 and are relying on Fed chairman Alan Greenspan’s stated “measured” approach to ease the transition to a higher rate environment.

However, given that the Fed is a long way off its usual rule for where interest rates should be for the current inflation and GDP figures, some bankers are less bullish. “The Fed has to catch up and so may make quicker moves than expected. If inflation rises much more, say to 2.5%, Fed Fund Rates at 3.5% are not unimaginable by the end of the year,” says Mr Cadiou.

As many EM issuers still have significant funding requirements for this year, ongoing EM investor uncertainty is a problem. The bond pipeline is already filling: both Brazil and Turkey still have $2bn to issue this year, and a slew of corporates is hoping to access the market. Mr Cadiou says: “Brazilian corporates have $24bn in amortisations before 2005 and they need fresh funds to finance this.”

Despite the challenging market conditions for EM bond issuers, most market players are taking a pragmatic view, perceiving the current difficulties as a short-term setback. Some of the more speculative hedge funds that ploughed into the asset class in the low interest rate environment may look elsewhere to invest.

However, barring any major negative EM country events, most other investors – including newer investors, such as the pension funds, which always had a longer-term investment approach – are likely to re-enter the asset class when the interest rate uncertainty has disappeared.

In the interim, EM bond issuers do have alternative financing sources, such as cash reserves or the international loan or local bond markets, so they are not up against a funding wall. The syndicated loan market, in particular, could help take up the funding slack if difficult EM bond issuance conditions endure for the rest of the year. Unlike the choppy bond markets, the floating rate loan markets are relationship-driven and credit-driven rather than technicals-driven. Consequently, they have weathered the US rate-driven uncertainty, registering neither a pricing increase nor a fall in liquidity in recent months.

ABN AMRO’s Mr Alam says: “Loan market volumes will increase as interest rates rise and the international bond markets look less appealing for issuers. Loan pricing will remain at the current low levels, barring any major external events. It is less volatile and is not driven by liquidity like the bond markets, but by fundamentals. And the fundamentals of most emerging market economies are still improving,”

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