Funds shrug off default risk in dash for emerging company bonds

Tue Dec 31, 2013 4:04am EST

* Record bond sales by emerging market firms despite defaults

* Study highlights currency mismatch risks

* Fund managers see negligible risk of default rush soon

By Sujata Rao

LONDON, Dec 31 (Reuters) - When Brazilian oil firm OGX tried to tap bond markets for $2 billion in 2011, investors were ready to hand it $5.5 billion. Two years on, OGX is in default and the debt trades at less than 10 cents of its original face value.

The spectre of such defaults spreading across emerging markets has not yet dimmed investor enthusiasm for the corporate debt sector, which saw record-high bond sales of $330 billion-plus in 2013 and more than 150 first-time borrowers.

Banks predict similar issuance for 2014, although the default of OGX and others - from Mexican homebuilders to Kazakh banks - are raising fears fund managers in the $1.4 trillion sector may end up with huge losses.

Default rates are so far only creeping up, with a rate of 3.1 percent this year after 2.7 percent last year and 1.6 percent in 2010, JPMorgan data shows, but concerns over explosive growth and a sometimes blind dash for yield are growing.

Dollar borrowing by companies has swelled tenfold since 2001, drawing in Chilean car dealers, Nigerian banks and Ukrainian poultry farmers.

The 8.5 percent coupon paid by OGX persuaded buyers to overlook the fact it was yet to generate any revenues and did not offer the collateral against default that is common practice for a first-time issuer.

Investors are so far unfazed, with 65 funds launched in 2012 and 2013, specifically to invest in emerging corporate debt, according to data from Thomson Reuters company Lipper.

All this amounts to what Princeton University academic Hyun Song Shin terms "the second phase of global liquidity", one where asset managers, rather than banks, have been the main players since 2010.

"When the current lull in global financial conditions is eventually broken by tighter dollar funding conditions due to U.S. Federal Reserve monetary tightening, the vulnerabilities (of emerging companies) are likely to be exposed once more," Shin said in a recent paper.

At the heart of this thesis is the issue of currency mismatch - where revenues or assets are in local currencies but debt is increasingly in dollars, a contradiction that may become more stark in future if the dollar strengthens.

Shin says the magnitude of the mismatch is underestimated because a large portion of the bonds are issued by U.S. or U.K.-based subsidiaries of emerging markets firms, but capital set aside by the parent firms to protect against default is usually in emerging currencies such as roubles or pesos.

So any wholesale deposit withdrawals by companies that run into trouble with their debt could in turn cause banking crises in the developing world.

Shamaila Khan, a portfolio manager at AllianceBernstein, says default rates will creep higher, but not explode. "You will see some of the repercussions of indiscriminate funding because of all the inflows the sector has received."

OVERBLOWN

Khan estimates default rates of 3.0-3.5 percent in 2013 and 2014. While that is far off the 10 percent rate seen in 2009 or the 30 percent rate of the late 1990s, it has risen off a 2011 trough of 0.6 percent.

Meanwhile not much corporate debt is due to be repaid in the near term, keeping the pressure off companies.

Rob Stewart, a client portfolio manager at JPMorgan Asset Management, reckons the peak of debt maturities will fall in a decade or so from now, as bonds issued during the current boom come up for redemption.

"The market is highly diversified, with a large number of countries, sectors and companies, so risks to asset managers from a default in one company or region are not high," he said.

It is also far too early to worry about a systemic crisis rooted in currency mismatch, says David Spegel, head of emerging debt strategy at ING Bank in New York.

He notes firstly that two-thirds of outstanding debt comes from energy and metals companies that have natural hedges in place in the form of hard currency revenues. Others, notably banks, often hedge bond payments via swaps during issuance.

Third, debt issued by external subsidiaries of emerging companies amounts to around $670 billion, Spegel calculates. But this comprises just 3 percent of the $19.5 trillion that is in bank deposits in the highest-risk countries, he says.

"In most cases, EM bank deposits are high enough to curb the suggested threat for the financial system," Spegel said.

And prices compensate for risks, many argue. Bill Perry, head of the corporate investment team at Stone Harbor Investments, notes the substantial yield premia that high-yield company debt offers, to U.S. Treasuries as well as junk-rated U.S. credit.

"You are getting a 200 bps in pick up when you pick EM high-yield over (developed market) high yield. You get paid a pickup and you get a comparable default rate," Perry said.

"Often when you buy high-yield names from emerging markets, you are buying very solid companies, they just come from the wrong zip code."

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

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