April 22, 2016 / 3:45 PM / 4 years ago

CORRECTED-INVESTMENT FOCUS- Emerging junk bonds face hazards after rally

(In para 11, clarifies that data from Gimme Credit references bonds listed on BAML bond index)

* EM miners, energy credits showing most distress

* Brazilian names boosted by impeachment prospects

* Defaults seen rising in 2016, with highest rates in LatAm

* GRAPHIC-Metals performance YTD: link.reuters.com/cag37s

By Claire Milhench

LONDON, April 22 (Reuters) - Defaults among junk-rated emerging market companies are ticking higher, spelling danger for yield-seeking investors who may have been lured back to these assets by this year’s price rallies in metals and oil.

Iron ore prices have jumped more than 50 percent this year, dragging up other base metals. Copper, for instance, is up almost 20 percent from its mid-January troughs. Oil has enjoyed a 65 percent trough-to-peak rally.

Those gains have given a new lease of life to commodity-linked assets, including the bonds of companies with sub-investment grade ratings, a large proportion of which are in the energy and mining sectors.

But many — including Goldman Sachs on Friday — see the commodities rally as unsustainable, and some bond investors are becoming more cautious.

“You are seeing more distress, and defaults are rising,” said Bill Perry, a fund manager at U.S.-based Stone Harbor Investment Partners. “We are wary about certain corporate credits. You have to be a lot more selective.”

Emerging junk bonds have outperformed this year, with yield spreads tightening 115 basis points (bps) in March alone — double the contraction in U.S. high-yield spreads, Bank of America Merrill Lynch (BAML) noted.

Year-to-date returns are a respectable 6-7 percent, according to BAML indexes, after the sector made its first loss last year since 2008. Then, amid global turmoil, around 15 percent of junk-rated emerging companies defaulted, data from ICBC Standard Bank shows.

Defaults on emerging junk bonds are now running at 3 percent of the total outstanding debt, up from 2.4 percent a year ago, BAML calculates. It predicts a 4.8 percent default rate in 2016.

March saw 17 defaults across emerging markets, the bank noted, ranging from Mexican construction company ICA to China’s Dongbei Steel.

Commodity names are emerging as the weakest links.

Cedric Rimaud, director of emerging markets research at U.S. research house Gimme Credit, noted that of the 779 emerging bonds listed on Bank of America ML’s non-financial EM corporate index, about 15 percent were considered distressed in early-April, indicating yields were 1,000 basis points above U.S. Treasuries with comparable maturities.

Of the 115 distressed bonds, 29 were in basic industries, including metals and mining, building and construction and steel producers, while 24 were energy names.


Many investors will point out that default rates for U.S. high yield names are higher, at 4.6 percent, and are forecast by ratings agency Moody’s to hit 6 percent by year-end.

That “improves the allure of emerging high-yield debt on a relative basis”, ICBC Standard Bank said.

Brazilian credits in particular have rallied hard, helped by the recovery in commodity prices and the prospect that left-wing President Dilma Rousseff will be impeached, potentially opening the way for a more business-friendly administration.

That is despite the fact that Brazil’s high-yield default rate is around 6.6 percent, according to the Standard Bank note.

Even non-commodity names, such as airline Gol and mobile operator Oi, are looking to renegotiate their debts.

Brazilian names that have rebounded include steel and iron ore producer Cia Siderúrgica Nacional and Samarco Mineração, an iron ore pellet producer. Samarco is still awaiting authorisation to resume iron ore mining operations at the site of a dam burst that killed 19 people.

Their bonds have almost doubled in price, although yields remain in the double digits .

But some question the sustainability of the Brazilian rally given that the economy is expected to shrink almost 4 percent this year.

“2016 is probably a bit early to buy into the reform story,” said Charles Robertson, global chief economist at Renaissance Capital. “Weak (economic growth) has a grinding effect on people’s solvency, and at some point that blows up.”

He drew parallels with U.S. coal company Peabody, which after the coal price collapse found itself unable to service its debt and filed for bankruptcy in April.

“It wouldn’t surprise me if we saw that happening in Brazil,” he said.

The rally in distressed names has been partly fuelled by inflows into emerging bond funds, which according to BAML have attracted $9.2 billion over the past nine weeks.

Now some managers are worried that the market has got ahead of itself, with little discrimination between highly levered companies and those with strong balance sheets.

“It almost seems as if people are just buying risk, it’s not (because of) improving fundamentals,” said Kathy Collins, an investment manager at Aberdeen Asset Management.

“It’s something we’re debating internally at the moment — is it time to cut a bit of risk because the next leg is going to be down?” (Editing by Catherine Evans)

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