While volatility has affected equity and high-yield debt markets, HSBC's head of debt capital markets sees opportunities from increased volumes in China and green bonds.

Since the then US Federal Reserve chairman Ben Bernanke announced a tapering of bond purchases by the central bank in mid-2013, fixed-income markets around the world have been analysing every word of every Fed statement. In the context of fears that eventual interest rate rises in the US would trigger heavy volatility in emerging markets, Fed vice-chairman Stanley Fischer’s speech at the annual meetings of the International Monetary Fund in October was unambiguous.

“Actions taken by the Federal Reserve influence economic conditions abroad. Because these international effects in turn spill back on the evolution of the US economy, we cannot make sensible monetary policy choices without taking them into account,” he told his audience.

With a local market network that has few rivals, HSBC is steeped in emerging market debt issuance as a core business line. The bank’s global head of debt capital markets, Bryan Pascoe, finds the new tone from the Fed reassuring.

“Concerns about US interest rates are on the backburner even compared with a few weeks ago. The Fed has been quite clear that it is externalising its view on interest rates and will be sensitive to worries about emerging market volatility, eurozone growth and the pressure of liquidity reduction in terms of how it impacts other markets,” says Mr Pascoe.

In addition to fragility resulting from the geopolitical situation in Russia and uncertainty in Brazil during the election period, there is renewed concern about deflation in the EU. Moreover, wage inflation in the US remains very low, so any rate rises will be gradual.

Nonetheless, the market has become more volatile, with heavy swings in equity and high-yield credit valuations, especially in the weaker European economic context. But Mr Pascoe says the primary market for credit remains favourable, and investors are still ready to commit funds to the segment.

“The low-rate environment is positive; solid inflows continue into investment-grade products, and emerging markets are benefiting as investors reassess opportunities after the very significant rally in peripheral names,” he says.

China rising

In 2014, that emerging market story has been completely dominated by Asian issuers for the first time. Russian issuance of $40bn in 2013 has been reduced to no more than $7bn because of sanctions imposed by the West, with the market looking set to remain closed for the rest of this year. Latin American issuance tends to be dominated by Brazil, which currently faces slower growth. And in the Middle East, local banks remain very liquid and the more heavily indebted corporates are still deleveraging.

“In China, we have seen an abrupt externalisation of the funding for state-owned enterprises as local banks face a more challenging domestic liquidity and economic environment. Chinese international issues accounted for about 1% of total emerging market international issuance in 2009, and that has now risen to about 25% year-to-date, making China the largest single country of issuance by far this year, a trend that we expect to continue,” says Mr Pascoe.

Chinese banks themselves are also preparing a wave of additional Tier 1 bonds to meet Basel III capital requirements and protect against any deterioration in asset quality. Bank of China received $23bn of orders for a $6.5bn perpetual deal in October, the first Basel III-eligible additional Tier 1 issue from a mainland Chinese bank.

Such a rapid expansion brings risks of its own, including concentration risk for investors. The Bank for International Settlements expressed concern in its third-quarter 2014 report that Chinese real estate companies with renminbi revenues are leveraging up in dollars, creating a currency mismatch. Mr Pascoe says there have also been high levels of cross-border paper from oil and gas companies or utilities, which are more natural users of the dollar funding market as they have hard currency revenues.

“At the moment, investors are driven more by the need to allocate funds instead of holding low-yielding cash, and investment decisions are not always driven by careful analysis of the fundamentals of individual issuers. But in the long term, it is positive for Chinese companies to diversify their funding sources and tap the deep pockets of the Asian private wealth management industry and asset managers,” he says.

The other face of China’s financial internationalisation is the growing use of the renminbi as an issuance currency for non-Chinese entities. The UK government’s Rmb3bn (about £300m, $480m, equivalent) three-year dim sum bond, launched in October 2014, was the first renminbi paper from a sovereign issuer aside from the Chinese government, and HSBC was a lead manager on the deal.

“Having a sophisticated issuer such as the UK Treasury validates the long-term sustainability of this market as a resilient source of funds and the renminbi as a key reserve currency of the future. In time we will see convergence of the onshore and offshore markets, and the Chinese authorities have been active in bringing offshore investors to China’s domestic bond market and looking to improve market infrastructure,” says Mr Pascoe.

Turn in leveraged finance

In Europe, Mr Pascoe expects renewed activity in the bank capital market, especially for additional Tier 1, once the European Central Bank’s Comprehensive Assessment is completed on October 26. Sovereign, supranational and agency issuers have been relatively quiet in the third quarter as they are already well funded, but corporates should look to prefinance 2015 given the attractive yields achievable. Moreover, Mr Pascoe says there is a growing pipeline to fund mergers and acquisitions activity in sectors including tobacco, telecommunications and healthcare, as companies take advantage of low rates to finance strategic moves.

The leveraged finance market is becoming less favourable, however. US regulators are beginning to sound increasing warnings on leveraged lending by banks, closing the door on a market that has been tapped increasingly by European borrowers in recent years. In Europe itself, banks are reluctant to hold leveraged finance assets due to the high capital costs they incur. And there are signs of a turn in the credit cycle for European leveraged finance – Italy is back in recession, France is fragile, and a warm third quarter appears to have hit sales at European retailers. A number of high-yield issues outstanding are risking a covenant test.

“Investors are starting to become more sensitive, but hopefully there can be a positive outcome. Some of the leveraged lending terms on transactions were very aggressive, so it is not necessarily a bad thing to have a correction that brings about more market discipline and sustainability, and there is still a good depth out there in terms of the asset management industry committed to this product,” says Mr Pascoe.

New opportunities

If leveraged finance looks set to face a more sceptical investor audience, then so-called green bonds – which take account of the environmental and social governance (ESG) of issuers – have suddenly started to receive a warmer welcome (see article on page 28). Mr Pascoe says the issuer pipeline has spread beyond supranationals and regional development banks to encompass corporates and emerging market borrowers keen to show their integrity in order to grow their investor base.

“The breadth and speed of development suggests this market is for real. But that also puts the pressure on to maintain credibility by showing that ESG principles are being imposed, with proper identification, monitoring and reporting,” he says.

Mr Pascoe foresees the emergence of a global governance model and validation scales that take in the full range of ESG indicators – not just environmental and climate change factors, but also the issuers’ social governance including contribution to education and healthcare. Norway’s Centre for International Climate and Environmental Research (Cicero) has established a reputation on the environmental side, but French company Vigeo is so far the only established player to assess the social governance side as well.

For HSBC, there is a chance to build on its extensive experience in Islamic finance, which, while driven by very different factors, also relies on validated adherence to a set of principles and rules.

“The Islamic finance market has made great progress in globalising the understanding of the validation of its processes and principles and engagement with specialist scholars over the past several years, which has helped it to become a mainstream product very quickly,” says Mr Pascoe. 


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