Investors seek solace in resilience of corporate credit

In early January 2016 the Institute of International Finance released data that showed unprecedented capital outflows from emerging markets. The headline figure – a dizzying $735 billion in 2015, following $111 billion in 2014 – flashed across the world and made the leap from financial media to mainstream news.

Underneath the headline statistic it quickly became clear how much China was dominating these outflows. The IIF calculated $676 billion of the $735 billion was directly related to China. In Latin America, that part of the outflow story was not a comfort. The region, strong on commodity-exporting companies, has long been seen by investors as a derivative of Chinese demand.

Latin America’s fixed income market has seen a collapse in primary issuance. According to Dealogic data, it fell from $133.2 billion in 2014 to $70.6 billion in 2015 and yields have increased markedly. But despite the bad news something interesting is happening.

Geoff Dennis, head of global EM strategy for UBS, questions why Latin America’s fixed income markets have seemingly dislocated from equity markets. Unlike equity markets, which have seen record outflows in 2014 (EPFR reports $11.9 billion) and strong outflows in 2015 ($6.9 billion), fixed income markets have merely repriced.

This, for Dennis, points to a possible downward lurch in bond prices to come as the two asset classes realign. However, others argue that there are new structural reasons to believe that Latin America’s bonds – sovereign and corporate, high grade and high yield, and hard and local currency – will resist large outflows and any messy capitulation crisis.

In truth, the signs of resilience are mixed. There are pockets of risk and each sub-asset class performs differently. But in contrast to the often-hysterical headlines predicting huge sell-offs and a wave of defaults, the mood among those involved in the markets is optimistic; cautiously optimistic, but upbeat nonetheless.

In the past, crises in Latin America have centred on sovereign risk. This time it is very different: with much lower levels of foreign currency debt. Brazil, for all its rating downgrades, has foreign debt worth just 2.4% of GDP and $360 billion of currency reserves. This absence of original sin has enabled the region’s central banks to let their currencies take the strain. That has clearly happened. The depreciation of all Latin American currencies in the last two years has been dramatic. Peru’s currency fell by 20.9% between June 2014 and February 2016, Mexico’s by 32%, while the Brazilian real and Colombian peso both fell by 44% over the same period.

While that strategy protects central bank reserves and sovereign credit ratings, it affects domestic economies in terms of higher pass-through inflation and, subsequently, rising borrowing costs, as monetary policy responds to bring down rising prices, and lower GDP growth. That places the stress on corporate borrowers. Hard-currency borrowing increases leverage and repayments hit cash flows. Rolling over debt becomes harder and local financing options also become more expensive.

All this news set in train a rash of coverage exemplified by a story in the Financial Times earlier this year, which ran under the stark sub-head ‘Devaluing EM currencies make it harder for issuers to repay dollar-based debts’. The story said: ‘Foreign currency bonds, mostly in US dollars, are attractive to EM borrowers because interest rates are lower than they would pay on local financial markets. But they can go wrong when EM currencies devalue, making it much harder for issuers to repay their debts, especially if their earnings have been hit by the precipitous fall in commodity prices over the past 18 months.’

According to some EM investors this narrative is misleading and dangerous.

“A lot of people who are not involved in EM on a day-to-day basis are making assumptions that US dollar debts in EM countries with devaluing currencies will see defaults go through the roof – but this just scratches the surface of the real dynamics,” says Gunter Heiland, co-head of the emerging markets debt group at Gramercy Funds. “These companies will now also have local labour costs that are cheaper, and the commodities as raw materials and energy they import are cheaper. And these are companies that sell to Europe and the US and therefore have hard-currency revenues,” he explains.

Geoffrey Hunter, head of emerging markets syndicate at Citi, agrees with this assessment and says the region’s companies are well placed to withstand the current financial dynamics. “I would argue that most of the companies that came to the [dollar-denominated debt] markets in the past few years are pretty damn good companies. Many of them are commodity companies, so they have been hurt in that regard but that also means they are less exposed to the FX problem – they have dollar revenues. That doesn’t mean they are out of the woods, but it does mean they aren’t directly exposed to the 50% movement in currencies – in some cases they are actually beneficiaries. I really can’t think of many weak businesses that have come to the market and therefore are in line to blow up – obviously there could be some but not many. There was a lot of discipline from investors in order to chase the good businesses and not subscribe to the less good stories.”

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