The repricing of risk

28/03/2009 | Sid Verma

Investors are taking stock of a radically changing landscape for Latin debt and equity. The investment case is being tested to the limit.

As the dust settled in the wake of the Lehman Brothers collapse, many predicted emerging market assets would rebound strongly from last autumn’s devastating lows – buoyed by the relative strength of developing economies.
But in the months since, the outlook has grown darker, with each progressive shade bringing back painful memories of crises past. Instead of pulling back, major indices have remained weak, reflecting acute risk aversion, a structural shift in global financial markets as well as the prospect of a severe and protracted global recession.
JPMorgan’s Emerging Markets Bond Index, having widened to a six-year high of 8.91% over US Treasuries last October, has since tightened only a touch to around 6.90% – in sharp contrast to its historic low of 1.65% in January 2007. Latin stocks have fallen 34.4% to date since the collapse of Lehman Brothers, according to Bank of America Securities-Merrill Lynch.
“The process of stabilizing the financial system on a national basis with fiscal resources has driven banks to withdraw credit, which has led to a collapse in trade and an unwinding of investor positions in emerging markets,” says Arnab Das, head of emerging market research at Dresdner Kleinwort. “There’s a material risk that the thesis for investing in emerging markets unravels.”
The financial landscape has changed beyond recognition, say analysts, and the intrinsic value of assets globally must adjust to reflect the end of abundant liquidity. “The destruction of real wealth has to be a part of the solution to this crisis, to bring the stock of assets back into line with the income streams that have to service them,” says Philip Poole, head of emerging market research at HSBC.
“The world is not good at destroying excess capacity,” notes Dresdner’s Das.
Claudia Calich, a senior emerging markets portfolio manager at Invesco in New York, adds that “the investor pool is shrinking globally, and there will also be fewer dealers and less liquidity.”
Meanwhile global markets remain highly volatile despite historically low interest rates as well as massive fiscal stimulus and banking sector bailouts in the West.

The view from the south
For Latin America – as for all markets – the outlook is acutely correlated with events in core markets of the West, and specifically whether the policy response in the US keeps the rest of the world open to finance and investment. Like never before, Latin American assets are locked in a tug-of-war between fundamental value – the structural strength of assets – and market technicals – volatile global price movements, says Andrea Kiguel, emerging market debt analyst at Barclays Capital.
Yet for now, Latin-focused fund managers believe they have plenty of ammunition as they fight redemption requests from fear-soaked investors. For a start, investors point out, Latin American assets have outperformed their EMEA (Europe, the Middle East and Africa) counterparts and some Asian markets over the past year.
High-yield Latin American corporate bonds in JPMorgan’s bond indices were down between 30% and 35% in 2008 compared with losses in emerging Europe at 43%. “Latin America has outperformed because it never had much leverage or a deep banking system, while fundamentals have improved vastly in recent years,” says Edwin Gutierrez, emerging debt portfolio manager at Aberdeen Asset Management in London.
The economics matter. Strong public and private balance sheets, reduced currency mismatches among borrowers, floating exchange rates and counter-cyclical policies have bolstered the region’s credit profile. Unlike the 1990s, Latin borrowers are now much less indebted, reducing the volume of debt defaults. Public borrowing is largely denominated in local currency, and floating currency regimes have helped serve as a shock absorber against the terms of trade decline triggered by the commodity price collapse.
Thanks to healthy foreign-exchange reserves, many Latin countries can – for now – buck the cycle of currency devaluations and debt defaults. Counter-cyclical fiscal policies and monetary easing could also help to safeguard the relative growth prospects of the region.
Strategic non-levered real money investors have historically been exposed to Latin America through external dollar-denominated bonds issued by governments or publicly-backed corporates. While local markets offer higher returns, enhanced sovereign creditworthiness and the increasing scarcity of government paper in recent years has meant the region’s external debt is increasingly viewed as a relatively safe asset class. Moreover, in the teeth of the market downturn, Latin assets have demonstrated relatively strong liquidity.
According to the Emerging Markets Traders Association (EMTA), Latin America accounted for the bulk of sovereign trades in the fourth quarter of 2008, comprising 57% of trading with a volume of $111 billion – the same proportion for the full 2008 trading at $575 billion. Indeed, Brazilian corporate and government paper accounts for 19.6% of all EM hard currency trades.
Investors have ploughed into such defensive plays on market dips since the onset of the financial crisis in August 2007.

No outperformance
But many doubt whether Latin sovereign debt can outperform G3 credit this year. High-yield corporate bonds in G3 markets look attractive by all historical comparisons – yielding 20% on average this year and representing roughly an 18% spread above US Treasuries. According to Pimco, it would take a 30% to 40% annualized default rate to wipe out those returns. “Why take on EM currency risk? It’s being crowded out. The diversification argument [for EM] has been weakened,” says Joyce Chang, head of emerging markets research at JPMorgan.
One large institutional investor revealed that crossover long buyers are now actively shunning investment-grade EM sovereigns for US high-yield corporates. As alarmingly, “massive borrowing by western nations will drain the already scarce liquidity” that could be put to work in emerging markets and thereby act as a further drag on prices, fears Paul Biszko, senior emerging markets analyst at RBC Capital Markets.
As a result, investment options increasingly fall into two camps: safe, liquid but expensive assets such as Brazil’s 2040 bonds, the most liquid global security in emerging markets which offers 8.75%; or paper with higher yield, such as from heterodox economies like Argentina, Venezuela and Ecuador, where default risks are high. Mainstream investors have cautiously built up exposure to the latter group, attracted by the risk-adjusted returns. EMTA calculates that Argentine hard currency trades in 2008 total around $89.6 billion, or 10.5% of all emerging sovereign trading that year. “The carry alone is attractive so these markets don’t need to rally,” says Gutierrez at Aberdeen, which has cautiously snapped up Argentine and Venezuelan debt in recent months.
Says Sam Finkelstein, emerging markets portfolio manager at Goldman Sachs Asset Management: “If you look at absolute levels of debt and their sheer ability to pay, these countries are not levered.” His firm has neutral exposure to Argentina but is overweight in Venezuela.
On the face of it, the pitch for strategic asset allocation into Latin corporate debt this year would seem a no-brainer. These bonds represent simple capital structures from lower-leveraged credits in countries at a different stage in their economic cycle than in the West; in theory, they also offer an extra yield to compensate for EM risk.

The fear factor
But widespread fear over liquidity and pricing levels has blown a hole in investor confidence in corporate bonds. Analysts are predicting huge adjustments in spreads and outright bankruptcies this year as the economic downturn intensifies. In particular, many fear the deteriorating financial health of the region’s large oil, gas and steel exporters as well as mid-tier firms whose revenues are tied to the commodity cycle.
Merrill Lynch’s high-yield emerging market corporate index at its current spread implies a default rate this year of 25% among issuers. The spread reflects not only the probability of default but also likely low recovery rates in the event that debt covenants are broken.
The global crisis has also forced investors to take stock of historical trends. EM credit had enjoyed a bull run since the 1997/8 Asian and Russian crises, thanks to expanding global output, declining external public debt and de-dollarization. These factors “changed the sensitivity of sovereign spreads with respect to global factors – most notably, risk-free international rates and corporate spreads in core markets,” says Kiguel at Barclays Capital.
But in today’s febrile climate, so-called risky assets are repriced at breakneck speed, since these markets are less liquid and so more prone to capital outflows. As a result, says Kiguel, “models based on the most recent period may understate the incidence of global factors.” They might also fail to capture the extent to which US high-yield corporate debt prices drive the performance of investment-grade emerging market bonds, he adds.
Latin-focused investors are now increasingly concerned with technical credit work as they figure out the right moment to snap up undervalued securities.
But this change in allocation philosophy – from banking on an intrinsic value of a credit to instead emphasizing relative valuation – has come at a time when investors’ confidence in calling the bottom of the market is being tested to the limit. The result has simply made investors more wary of upping exposure to Latin credit.

The local bid
Fund managers are now also more selective about Latin local credit markets: many managers have cut local currency exposure in the wake of a strengthening dollar and the precipitous drop in commodity prices.
Local currencies – once touted by some as relatively immune from global asset repricing – are not the one-way appreciation bet many had presumed. Moreover, as commodity prices continue to plumb the depths, local currency weakness looms large for the foreseeable future. As a result, Latin currency markets are trading with increasingly less liquidity, a fact which only exacerbates large swings on low market volumes, while local currencies remain victim to unpredictable shifts in global risk appetite.
“I am reticent on Latin currency trades despite the fundamental value. We have had and continue to see a lot of volatility, and with the region’s declining terms of trade, exchange rate weakness could continue this year,” says Gutierrez. Long local currency trades are no longer a popular risk/return trade-off as a strategy to achieve out-performance.
Some would still argue that investors should now snap up local currency long-duration assets before Latin central banks slash rates further. But George Estes, analyst for the $4 billion emerging country debt fund at US-based Grantham, Mayo, Van Otterloo (GMO), says rate cuts are all priced in local currency debt. “You are not being paid much above short-term interest rates,” he says.

Taking stock
So far the collapse of commodity prices has hit stock markets more severely than bond markets. Battered by the collapse in oil prices and capital outflows, the MSCI Latin America Index dropped 53% in US dollar terms in 2008 versus 2007’s 47% rise.
The region remains dogged by currency weakness and slowing economic growth, all bets are off on whether the bottom of the market has been reached. In fact, analysts expect Latin credit markets to outperform equity markets comfortably this year as disinflation looms large.
Eric Jayaweera, an emerging market trader at UBS, observes that equity investors are increasingly snapping up Latin paper. The investment case is made more compelling considering the expected earning yields for emerging equities are 10% for 2009 compared with the 11% returns that investment grade corporate bonds are offering.
The financial crisis has reordered the pricing levels, market functioning and investor base for all emerging markets. “There are very few Latin-specific factors that will determine Latin bond and stock markets this year,” says Paul Biszko at RBC Capital Markets.
But a silver lining from this crisis for Latin America could emerge if and when the world economy eventually picks itself up. Marc Balston, head of emerging markets quantitative research at Deutsche Bank, sums it up: “After this crisis, those Latin countries that come out relatively unscathed relative to EMEA will have their reputations amongst investors seriously enhanced.”

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