Global Investing

Anticipating the fallout from South Africa’s ratings reviews

South Africa is due ratings reviews this Friday. Chances are that the Standard & Poor’s agency will cut its BBB rating by one, or possibly even two notches.  Another agency Fitch has a stable outlook on the rating but could still choose to downgrade the rating rather than the outlook. What will be the damage?

There is undoubtedly a link between ratings and bond prices.  So a one-notch ratings downgrade tends to lead to roughly a 20 percent increase in bond yield spreads and credit default swaps (instruments that are used to hedge against default), according to calculations by JPMorgan. But in South Africa the lower credit rating may already be already reflected in asset prices — Panama, Brazil, Colombia, Philippines, Uruguay, Indonesia, and Romania carry lower sovereign credit ratings but boast lower CDS and dollar bond yield premia over Treasuries.  Russia and Turkey have lower average ratings than South Africa but their debt and CDS spreads  are roughly on the same level.

So a ratings cut is unlikely to trigger huge outflows from South African debt markets, says JPMorgan, which runs the most widely used emerging bond indices. In Brazil for instance, a well-anticipated  downgrade back in March did not lead to significant cash outflows from its markets, JPM points out:

The current relationships between spreads and ratings do not necessarily imply another step wider in South Africa’s spreads until it is firmly sub-investment grade (not J.P. Morgan’s base case).

Secondly, even after a downgrade to BBB-, South Africa would still be rated investment grade, so investors will not be required to sell their holdings.  On local currency debt, South Africa is rated A- from S&P so a 1- or even 2-notch downgrade should have no technical impact the bank argues.

Record year for emerging corporate bonds

The past 24 hours have brought news of more fund launches targeting emerging corporate debt;  Barings and HSBC have started a fund each while ING Investment Management said its fund launched late last year had crossed $100 million.  We have written about the seemingly insatiable demand  for corporate emerging bonds in recent months,  with the asset class last month surpassing the $1 trillion mark.  Data from Thomson Reuters shows today that a record $263 billion worth of EM corporate debt has already been underwritten this year by banks, more than a fifth higher than was issued in the same 2011 period (see graphic):

The biggest surge has come from Latin America, the data shows, with Brazilian companies accounting for one-fifth of the issuance. A $7 billion bond from Brazil’s state oil firm Petrobras was the second biggest global emerging market bond ever.

The top 10 EM corporate bonds of the year:  Petrobras issued the two biggest bonds of $7 billion and $3 billion, followed by Venezuela’s PDVSA and Indonesia’s Petramina. Brazil’s Santander Leasing was in fifth place, Mexican firms PEMEX and America Movil were sixth and seventh.  Chilean miner CODELCO, Brazil’s Banco do Brasil and  Russia’s Sberbank also entered the list.

Emerging EU and the end of “naked” CDS

JP Morgan has an interesting take on the stupendous recent rally in the credit default swaps (CDS) of countries such as Poland and Hungary which are considered emerging markets, yet are members of the European Union. Analysts at the bank link the moves to the EU’s upcoming ban on “naked” sovereign CDS trades — trade in CDS by investors who don’t have ownership of the underlying government debt. The ban which comes into effect on Nov. 1, was brought in during 2010 after EU politicians alleged that hedge funds short-selling Greek CDS had exacerbated the crisis.

JP Morgan notes that the sovereign CDS of a group of emerging EU members (Bulgaria, Croatia, Hungary, Lithuania, Poland and Romania) have tightened 100 basis points since the start of September, while a basket of emerging peers including Brazil, Indonesia and Turkey saw CDS tighten just 39 bps. See the graphic below:

 

Spread tightening was of a similar magnitude in both groups before this period, JPM says (the implication being that traders have been selling some of their “naked” CDS holdings in these markets ahead of the ban):

Emerging market local bond rally has more legs

Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.

There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.

Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes: