It is fair to say that over the last 12 months, most of the volatility in emerging market debt has been driven by developed markets (especially by the actions of policymakers), rather than emerging markets. However, in recent weeks, the reasons for developed market volatility have become more nuanced, with financials all of a sudden back in the spotlight.
As is often the case, there are a few layers to consider when looking at the impact on emerging market debt. First and foremost, while no Credit Suisse bonds are included in the EM corporate fixed income universe, the asset class has been affected broadly, with a generalised widening in credit spreads and investment grade outperforming high yield names. As is often the case in these kinds of scenarios, “sell first, ask questions later” has been the general mantra from investors.
Second, there has been a clear impact on financials in emerging markets. The broad EM corporate debt universe has roughly 30% exposure to the financials sector. More positively, when taking a closer look at EM corporate debt, the relevance of Additional Tier 1 (AT1) bonds is much more limited, at roughly 4%, and an additional 5.5% of classic subordinated bonds or Tier 2 bonds. In terms of the EM AT1 universe, roughly half of the debt is Asian, with Hong Kong, Thailand, Singapore, South Korea and China being the most represented countries (in this order). The remaining portion comes mostly from the Middle East, and to a more limited extent from Latin America.
As mentioned above, emerging market AT1s were not immune to the sell-offs, with these bonds dropping anywhere between 10% and 20% on a price basis. However, as is often the case, as the first wave of panic selling gradually came to an end, investors started to look more closely at this small segment of the emerging market corporate debt universe.
Importantly, the size of the market is relatively contained but distributed across a wide number of issuers. Most of these issuers still exhibit relatively strong fundamentals, and in the absence of unforeseeable bank runs, look in decent shape. Nevertheless, as the Credit Suisse case shows, any bank facing a meaningful drawdown in deposits could find itself in a complex position. As such, looking only at capital ratios is not sufficient; detailed analysis of liquidity and stickiness of deposit base is essential, highlighting the benefits of taking an active management approach, with a focus on credit selection.
The Credit Suisse collapse has shown that regulatory capital instruments and their ultimate payoff involve a certain level of interpretation from regulators. According to the Swiss regulator, Credit Suisse had reached a “point of non-viability”, meaning that the bank was deemed unable to continue without support. The need of such support, together with a law passed overnight, gave them the space to write-down the AT1 bonds, as defined in the final terms.
Asian AT1s, representing more than half of the EM AT1 universe, are effectively characterised by wording not too different from that of the Credit Suisse instruments, with the majority of the instruments encompassing the provision of a permanent write down. However, historically, Asian regulators have demonstrated a more bond-friendly approach. We saw a recent example of this in South Korea at the end of last year, where, after one issuer decided to extend a specific instrument to avoid market turmoil, support for a call back was arranged by the regulator. Historically, Hong Kong banks have also been supportive of non-economic call backs. Furthermore, since the resolution of the Credit Suisse rescue deal, Asia’s banking regulators, including HKMA (Hong Kong) and MAS (Singapore), have explicitly stated that AT1 instruments rank senior to shareholders.
To sum up, the attitude from any individual regulator can be an extremely important factor for investors, as there’s room for interpretation when it comes to the terms included in instruments’ documentation. Additionally, it’s worth noting that banks in emerging markets are usually locally or regionally focused traditional commercial banks, with relatively small investment banking businesses compared to that of their developed market counterparts. Most AT1 issuing banks are also their respective national or regional “champions”.
Overall, we feel that the recent volatility has provided some interesting opportunities for us to add exposure to relatively solid banking groups at very attractive levels via Additional Tier 1 instruments, Tier 2 or Senior bonds depending on the situation. More specifically, we have recently opened new positions in banks in Qatar, Hong Kong and Mexico at what we considered to be very attractive entry points.
Broadly speaking, recent events have resulted in spread widening, which many investors were waiting for in emerging markets. The asset class looks cheaper today versus US treasuries and can provide meaningful long-term return prospects given the high starting yield to maturity. Recent events suggest that lending standards could tighten in developed markets, and the highly anticipated slowdown could be one step closer. As such, we think there might be some additional volatility ahead for risk assets.
When investing in developing geographical areas, there is a greater risk of volatility due to political and economic change; fees and expenses tend to be higher than in western markets. These markets are typically less liquid, with trading and settlement systems that are generally less reliable than in developed markets.
When investing in bonds which have a low rating or are not rated by a credit rating agency including high yield and distressed bonds, while such bonds may offer a higher income, the interest paid on them and their capital value is at greater risk of not being repaid, particularly during periods of changing market conditions.
Investments in contingent convertible bonds (CoCos) may result in material losses based on certain trigger events. The existence of these trigger events creates a different type of risk from traditional bonds and may result in a partial or total loss of value or alternatively they may be converted into shares of the issuing company which may also have suffered a loss in value.
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