Renewed warning of EM credit blow-up

Fears that monetary tightening by the US Federal Reserve could trigger panic selling by emerging market bond-holders has sparked a renewed blowup warning.

Hyun Song Shin, head of research at the Bank of International Settlements (BIS), noted that investors’ search for yield had increased average emerging market debt (EMD) duration, exacerbating potential price volatility.

Shin – who has been warning about an EM crisis since last November* – reiterated his call at a BIS annual general meeting recently. He has pointed to the shift of EM corporate credit from bank balance sheets to asset managers’ bond portfolios, referring to it as the second phase of global liquidity.

This has been accompanied by a shift from local currency to US dollar debt as developed market investors who have replaced banks in bond financing have preferred to lend in their home (or close-to-home) currency.

Already EM bond holders have shown themselves to be a jumpy bunch, as demonstrated once former Fed chairman Ben Bernanke first raised the prospect of the US central bank tapering its largescale asset purchasing programme in May last year.

Shin has warned that a bigger sell-off will break once the Fed begins to raise interest rates that could potentially overrun even the best-prepared EM central banks.

The premise of his latest research paper is that asset managers’ search for yield has meant they are now holding far more duration in EM bonds than in previous years.

The illustration below shows how average duration of bonds (‘y axis’) issued by non-bank corporates in emerging markets has grown since the financial crisis, just as gross issuance has increased (size of circles).

Both these forces act together to increase the share of longer-duration bonds in the total universe held by asset managers. This is good for issuers – they don’t need to worry about refinancing the debt or paying it off for a while longer.

But it’s bad for asset managers because of the greater sensitivity that longer-dated bonds have to changing interest rates: the prospect of higher interest rates is a bigger problem for bond holders who have locked in lower rates for longer. Average maturity rates are a good proxy for duration risk.

Shin pointed to a second structural weakness from investor fears about EM currencies. The shift from bank to bond debt has been marked by a shift from local currency to dollar debt. Most debt issued by corporates offshore is in dollars, and the charts below show how offshore issuance has boomed for firms in China and Brazil.

Shin had already raised concerns about EM corporates’ ability to service this debt if local currencies weaken, as they did in summer last year. This would create a mismatch between a firm’s revenues (local currency) and its debt servicing obligations (dollar).

Asset managers have countered that there is no mismatch because globalisation has meant EM firms now have a much bigger portion of their revenues in dollars. That may be true for large EM energy companies such as Brazil’s Petrobas or Mexico’s Pemex, but what about Chinese property companies, which have been issuing via Cayman subsidiaries?

And while this may work for servicing debt payments, what happens when bonds need to be repayed? Issuance of US dollar bonds in emerging markets all but dried up last June, as the below chart of US dollar bond issuance by Asian corporates demonstrates (wk 23 corresponds to June 10).

What happens to companies such as Petrobas or Pemex then, let alone a Chinese property firm, if they don’t have the option to roll over big bonds when they become due? It’s unlikely they will be hoarding dollar reserves in case liquidity dries up to protect them, because the quantities are so large.

The refinancing challenge may have got further away due to increased duration, but it’s still not that far off. The chart below points to projected redemptions on international debt securities of non-bank corporations in emerging markets (note how much larger the figures measured by nationality are by residence).

Repayment obligations for US dollar debt – the pink bars – are growing at a good lick until 2018. Perhaps this will be enough to spook asset managers holding EM bonds?

* See AsianInvestor magazine’s May 2014 issue.