Analysis: Emerging borrowers face rollover risk, default threat

LONDON Fri Dec 16, 2011 10:58am EST

LONDON (Reuters) - Scarce dollar funding and a retrenchment in bank lending will force up premiums for emerging market countries and companies refinancing debt next year, adding to strains on public finances and potentially triggering a surge in corporate defaults.

JPMorgan calculates that emerging sovereign debtors will need to find $63.6 billion to cover coupon and redemption payments in 2012 while corporates must raise $107 billion. Total issuance should be around $245 billion, the bank forecasts.

Such volumes would not usually portend difficulty -- even this year, emerging bond issuance has been over $250 billion, not far off last year's record. But with markets still awaiting a solution to the euro zone's debt crisis, 2012 could be tough for entities that need to refinance debt or secure new money.

That is especially true for weaker names, both sovereign and corporate, with many of the latter already seeing their debt trading at levels that imply default.

Few expect any emerging sovereigns to default on debt next year. But fears are growing of a "crowding out" effect, as many borrowers -- from developed as well as emerging economies -- compete for limited funds on international capital markets.

Cash-starved European banks are actively shrinking non-core lending, with emerging markets a particular target. Dollar funding costs have surged to three-year highs in recent weeks as investors, keen to hold onto scarce dollars, pull back from making loans not secured by assets.

And within emerging markets, growth is slowing, making the investment story less compelling. That is reflected in a deterioration in credit ratings, especially in eastern Europe.

"The main theme in 2012 will be that quality matters. Given the uncertainty over the global outlook, investors will either look for quality or ask for a significant premium," said Nicolas Schlotthauer, who oversees $2.5 billion in emerging markets debt at DB Advisors in Frankfurt.

Issuers are already being forced to cough up to place paper, with even AA/Aa2-rated Qatar recently paying a 40 basis point premium to an old five-year bond to raise funds. Abu Dhabi's AA-rated state energy company IPIC meanwhile paid 90 bps over existing debt of lower-rated Mexican state oil firm Pemex to sell bonds last month.

CORPORATE STRESS

On the flip side, these credits have benefited from risk-aversion that has driven a huge rally in U.S. Treasuries. Qatar was able to raise 30-year cash at a cost of just 5.8 percent despite the hefty premium investors demanded over U.S. debt.

But for speculative-grade corporate credits, rated BB+ or lower, there may be no such silver lining. A third of debt falling due in 2012 from emerging corporates is junk-rated.

"For those credits that can come to market, the stress is exhibited via wider spreads. The real crowding-out damage may occur with poorly rated and weakening credits in the corporate sector," said Jeremy Brewin, a fund manager at Aviva Investors.

"Weak sovereigns can engage an IMF program. Weak corporates cannot. That suggests default risk will increase in the high-yield space," he added.

At present, emerging markets corporate default rates are a relatively low 0.7 percent. But JPMorgan analysts noted the main CEMBI index for high-yield corporate bonds is trading at spread levels that imply a 5 percent risk of default within one year.

Such firms are already having trouble raising cash. ING Bank notes that speculative grade companies have accounted for just 10 percent of emerging bond issuance in the last quarter of 2011 rather than 20-35 percent that would usually be expected.

The bank said corporate bonds worth $82 billion were trading at distressed levels -- with a yield premium of more than 1,000 basis points over U.S. Treasuries -- at the end of November.

"Distressed conditions are approaching levels seen over 2008-2009 ... Prohibitive borrowing costs can lead to higher incidents of default within three to six months," ING added.

One big risk is the impact of Western banks' deleveraging on the syndicated loan market.

About $250 billion of loans fall due in 2012 across the emerging world, according to Thomson Reuters Loan Pricing Corp. Banks may be less keen to roll over these maturing volumes, preferring instead to repatriate cash, which could force borrowers -- mainly companies -- to compete in bond markets.

Few, however, predict a return to the 10 percent corporate default rate seen in 2009 after Lehman Brothers collapsed.

ING expects high-yield corporate defaults to hit 1.7 percent, three times 2011 levels. JPMorgan predicts 2.6 percent, noting that companies have used their huge borrowings of the past two years to build up cash positions and extend maturities.

SOVEREIGN RISK

Nor are sovereigns entirely without risk.

Countries such as Hungary, Dubai, Poland and Russia have higher-than-average repayments in 2012, Deutsche Bank says, while Ukraine must repay more than $1 billion of debt next year.

"None appears more at risk than Ukraine which is facing a clear financing squeeze, both in terms of domestic and international finance. Within EM, this could be the key credit to watch over the coming months," Deutsche told clients.

The huge volumes of euro zone and U.S. debt maturing next year could be a further challenge, especially given the high yields currently offered by sovereigns such as Italy and Spain.

"In our view there could be a major crowding effect as EM issuers compete in the same credit category as developed markets, which in turn would put more pressure on funding costs," Morgan Stanley analysts warned in a note.

(Additional reporting by Darren Maharaj of Thomson Reuters Loan Pricing Corp.; Editing by Catherine Evans)

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