On April 12, stronger-than-expected US employment data was released. Many economists and dealers duly predicted the Fed would be forced to raise rates steeply, some suggesting a hike of as much as 3% this year to stave off inflation.
Those expectations hit both emerging markets and high-yield debt hard. In part, traders predicted some emerging markets borrowers were going to have difficulty rolling over debt in a higher interest rate environment. Others blamed the sell-off on hedge funds unwinding ‘carry trades’, having borrowed in western markets to invest in higher-yielding emerging market paper.
The sell-off was brief and intense. The JPMorgan Emerging Markets Bond Index (Embi) fell from a high of 307 on April 1 to a low of 275 on May 10. Many new issues were pulled, particularly from Russia.
That country had its own internal problems, with the Yukos case dragging on through the summer, and a mini-banking crisis further worsening investor sentiment (see Credit, September, pp 60–63). One or two new issues came to market, but at reduced sizes and with coupons 2% higher than before the sell-off. For most issuers, the market was effectively closed.
However, the market beyond Russia quickly recovered. By mid-July, the Embi index was back to 300, and it has risen steadily ever since, to 316 at the time of writing. New issuance recovered strongly, with plenty of deals from Latin America. Brazil, which has the best-performing currency this year, brought a new issue which was heavily oversubscribed in early September. A few weeks later, Banco do Brasil was able to bring a $300 million 10-year deal which it had been forced to pull in August when the market was less receptive.
Russia has also seen a recent flurry of new issuance. Russian Standard Bank, MDM Financial, Bank of Moscow and Norilsk Nickel have brought new issues, with City of Moscow and Alfa Bank also poised to enter the market. Some of these deals have priced significantly tighter than Russian corporate deals before the mini-crisis in April.
New or second-tier names are now coming to market. Tatneft, Megafon, Rosbank, Serbia and Gazprombank all plan to launch deals later this year, in addition to more established names such as Alfa Bank, Kazkommertsbank, China, Venezuela, Vneshtorgbank and Guatemala. One dealer says: “The market is on fire right now. There’s been a complete turnaround from May.”
Why is the market doing so well, having had such a rocky summer? The main reason is that economic data from the US, particularly employment figures, show the US economy is not recovering as quickly as people thought. Raphael Kassin, the seasoned head of emerging market fixed income at ABN Amro Asset Management, says the market overreacted in April. “People saw two months of data, and thought there would be a fully fledged bounce-back in the US,” he says. “People – supposed professionals – were calling for the Fed funds rate to rise by 2% or 3%. It was a panic-type analysis.”
Jerome Booth, head of research at Ashmore Investment, says: “Some people in the market are still fixated in the mentality of cyclicality. They think there has to be a steep correction or a crisis. But what we’re really seeing is a steady improvement in fundamentals.” That has been borne out by a raft of ratings upgrades in the last few weeks, including Brazil, Turkey, Ukraine and Venezuela.
As pension funds regain confidence in the asset class, cash has begun to flow back into EM funds. Between April and August, investors pulled out over $1 billion from EM funds, according to EmergingPortfolio.com, a fund tracking company. However, since the beginning of August, the trend has reversed, with around $400 million flowing back into funds.
Many long-only funds, such as ABN Amro’s emerging market fund, are long on cash right now and looking to invest. William Weaver, director of DCM at Citigroup, says: “Bond investors have been sitting on the sidelines as liquidity has been low and the supply of quality paper scarce. However, with the reopening of markets in September after the summer lull, liquidity was rapidly replenished.”
In addition, a lot of EM debt is due to mature over the next two months. Carlyle Peake, director of DCM at Dresdner Kleinwort Wasserstein, says: “Almost all EM deals have been hugely oversubscribed. A lot of debt is maturing in September and October – as much as $5 billion – so that will be looking for a home too.”
This “wall of money”, as one syndicate desk member calls it, should make a success of most of the new issues in the fourth quarter. However, some clouds remain on the horizon. For one thing, a degree of uncertainty exists over the amount of leverage still in the market. Most big investment banks now run large and aggressive proprietary desks. As Citigroup’s single €12 billion trade in the European government bond market shows, these desks have the power to swing the market drastically in a single day. One hedge fund says JPMorgan runs a particularly aggressive EM proprietary desk, and that it was one of the heaviest sellers of debt in May.
Even long-only investors are becoming more exotic in their trades. Mohammed El-Erian, fund manager of Pimco’s emerging market funds, says one of the most lucrative trades Pimco has been using has involved selling protection to other investors through credit default swaps (CDSs). Such CDS trades are increasingly common in emerging markets. While Ashmore’s Booth argues that banks and investors are better equipped than ever before to deal with risk, other market commentators are concerned about how robust risk protection is in emerging markets.
A second potential fly in the ointment is Russia. Both investors and dealers seem to have made a mutual agreement to hold their nose and ignore the problems of the summer. Peake of Dresdner says that the summer’s volatility was caused by Yukos and the mini-banking crisis, but “now there is more stability in the financial sector, and we’ve had more news on Yukos, which has comforted the market.” But this is not wholly true. The fate of Yukos is still far from clear, and the banking sector is only stable because the central bank temporarily suspended reforms.
The market’s short-term amnesia regarding Russia’s problems is illustrated by the success of new issues, including some less than transparent banks, such as MDM Financial, and companies clearly exposed to the same ‘oligarchic’ risk as Yukos, such as Norilsk Nickel.
The same month Norilsk came to the bond market, HSBC pulled out of arranging a loan to it because of concerns over Yukos-style risk. Weaver at Citigroup, which arranged the $500 million Norilsk bond deal together with Morgan Stanley, says: “The funding challenges seen in the loan market in recent weeks did not have the same impact in the bond markets.” But which class of investor is better positioned to know a credit – a lending bank or a bond investor?
Weaver adds: “Investors did ask questions about Yukos, and about Norilsk’s tax position and relationship with the Kremlin. But they were easily answered: Norilsk has never used tax optimisation schemes, and its owner has no stated political ambitions.”
This seems optimistic. Everyone in Russia has done something in their corporate past that could be held against them, if the Kremlin decided to redistribute its assets. Fixed-income analysts and investors assert that Yukos was a one-off, but it is the latest in a string of ‘one-off’ battles between Putin and various oligarchs.
The bond market may be looking at corporate Russia through rose-tinted spectacles because of the market’s high liquidity and investment needs. Clearly, Russia remains in a strong funding position, but the power struggle between the Kremlin and the private sector has a few rounds to go yet.