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Smooth Sailing Ahead?

May 1, 2012

Positive sentiment returns and investors should be spoiled for choice. With uncertainties ahead, however, selectivity is the message from top bond managers.

by Mariana Santibáñez

Global volatility has not gone away. However, the longer it persists in the background, the more LatAm assets appear to have learned to ignore it and get on with things. Better news from Europe and the US was also helping at the beginning of the year, and there were signs of bulls emerging on the buy and sell sides.

Bucking the pessimism that characterized the second half of 2011, LatAm borrowers issued $43.2 billion in international bonds during the first quarter, up 41% on the same period in 2011, according to Dealogic. LatAm’s total comes out of an EM total of $139.0 billion in the first quarter, which was also up 41% from the corresponding period in 2011.

For nearly four years, EM debt investors have branched out into new areas of risk, often during rallies on the back of slumps induced by external fears. As with years past, these managers continue to look at LatAm as a reasonably safe place to invest.

The record issuance offers a wide selection, but it also means potential disappointments from weaker credits. In the corporate space, quality debut names have had and continue to have access to the dollar markets, offering investors as diverse a selection as they have ever seen out of the region. Learning from the past, investors say the current market does not justify being aggressive, despite the need for yield.

"Extended periods of technically-driven rallies tend to provide investors with a false sense of security," Robert Abad, Western Asset’s senior emerging markets analyst, says. Western’s EM debt fund returned 21.44% in the three years to March 31, according to Lipper. This compares to a 15.99% return in the same period by the JPMorgan EMBI index, and an 18.67% average for EM bond funds tracked by Lipper.

During bouts of volatility in the bond market, high-yield names are the first to suffer on the corporate and sovereign front. European volatility has been milder this year than last, but it continues to impact portfolios. The best protection from volatility is a greater emphasis on liquidity.

"In the search for yield, basic principles of EM risk management such as country risk analysis and corporate liquidity stress test scenarios have been thrown out the window," Abad says, adding that the last three years have seen a big technically-driven rally. When G4 central banks embark on a coordinated effort to flatten government yields, capital flows are pushed towards risky asset classes, resulting in the type of spread compression observed in the EMBI and CEMBI, he adds.

"December 2011 was an inflection point, as we added a bit more risk through January 2012," says Matias Silvani, portfolio manager and co-head of JPMorgan’s emerging market debt team. The JPMorgan Emerging Markets Debt fund returned 21.36% in the three years to March 31, according to Lipper.

Silvani explains that technicals and valuations became an important trigger, as inflows into EM debt picked up on the back of attractive valuations and improving fundamentals. While he has seen a favorable environment conducive to adding risk, idiosyncratic risk is going up as well, and volatility is likely to pick up going forward. Mainly, this means not buying into small bonds that the market doesn’t want due to illiquidity, he says.

"While fund managers have taken on more risk this year, they have done so more selectively than during past bull market periods for EM debt," says Blaise Antin, head of TCW’s sovereign research team. The TCW Emerging Markets Income Fund returned 23.52% through the three years to March 31.

Thanks to low dollar funding costs and a lot of money flowing into the asset class, Antin explains, the first three months of 2012 saw the heaviest single quarter of issuance ever in the dollar market for emerging market debt, allowing TCW to be active in many new deals. EM Bond funds had recorded a net inflow of $10.75 billion through April 5, according to Barclays Capital.

TCW likes the LatAm story because it’s further removed from some of the global problems, Antin says. The fund takes comfort in the fact that several LatAm countries, such as Peru and Chile, are more correlated to China than to Europe. 

Time to be Cautious

The story is now a familiar one, playing out as long as the developed world keeps interest rates low. The search for yield pushes investors to look into high-yield territory, local currency and USD-denominated bonds issued by emerging market corporates they may have overlooked in the past. With banks facing stricter regulations and reluctant to make loans, they are pushing new issuers to skip an important step in the financing process – in which banks used to fill the gaps with short maturity loans in the early stages of the business. More issuers, specifically in the growing single B category, are tapping the market at high coupons that could potentially spell trouble down the road should global liquidity conditions contract.

This continued deluge of issuance that includes first-time issuers can result in information overload and greater complacency on both the buy side and sell side as market participants try to keep pace with market developments, Abad says. He notes a growing tendency for less experienced EM investors to take due diligence shortcuts for the sake of maintaining performance, while more experienced hands who have lived through various market cycles are more cautious.

Double and single B rated transactions accounted for $7.03 billion, or 13.0%, of the total issuance in LatAm in the first quarter, compared to $11.05 billion in the first quarter of 2011, which represented 26.76% of the quarter’s total volume, according to Dealogic. Even if the lower-rated credits account for a smaller share than last year, their presence is encouraging given the pessimism expressed by so many late last year.

"The big surprise of 2012 is how quickly single B names were able to come back to market," says Eric Ollom, director of LatAm corporate credit strategy at Citi. "The new issuance is one of the market impacts coming from banks constraining their lending to the region. We saw high-yield names that couldn’t get deals done and then we saw brand new names like Cabcorp emerge. I do think there is appetite for interesting credits."

Ollom refers to Guatemala’s Central American Bottling Corporation, or Cabcorp, which sold a Ba2/BB/BB+ $200 million 2022 bond in February 2012, getting a 7.0% yield. Another successful debut came from asparagus and avocado exporter Camposol, which raised a $125 million B3/B bond at 10% yield in January. The trail is also full of high-yield issuers who didn’t make it, including BB- Dominican port operator Caucedo, and B3/B minus Brazilian sugar and ethanol company Grupo Farias.

Abad says Western Asset prefers B and BB rated exposure to Latin American issuers, with an emphasis on upstream oil and gas producers in South America and select telecom and media operators in Mexico and the Caribbean.

"We feel these bonds have the potential to outperform relative to their regional EM and developed world counterparts, given their relative strong liquidity and leverage metric," Abad says. "The combination of relatively stronger fundamentals and risk-return characteristics make them a better defensive play than offered by higher-yielding credits in other sectors such as banks, which have greater probability of being impacted by the European sovereign debt problem." 

"With excess cash sitting on the sidelines, and an increase of new names to the bond market, investors need to become more selective on new potentially illiquid names that have come to market – the big theme this year is to be cautious," says Roberto Sanchez-Dahl, senior portfolio manager and senior investment analyst at Federated, whose Emerging Markets Debt Fund returned 23.25% through the three years to March 31.

The Local Question

While previous rallies have been characterized by bullish moves into local currency debt, conditions at the moment may be less favorable. This also manifests itself in fewer cross-border local currency issuances early this year, though a 3 billion real global issuance from Brazil in April could change that. Antin says TCW has reduced exposure to EM local currency compared to mid-2011. TCW has increased exposure to sovereigns.

"EM currencies rallied sharply during the first two months of 2012, reducing some of the attraction in the very short term," Antin says. "Of course, with a medium- to long-term view, EM local currency bonds make a ton of sense because EM currencies are very likely to appreciate over time against the dollar, the euro and the yen."

"We also like the Venezuela story right now because oil prices are high and it appears increasingly likely that there will be a political change in Venezuela," Antin says.

"There is more appetite in the market to deal with Venezuela this year relative to last, thanks to this year’s elections and the overall political transformation, which in our view has started regardless of the election outcome," Silvani says. He sees attractive value in Mexican, Peruvian and Brazilian corporate and sovereign bonds.

"Venezuela has had a very good performance and has closest correlation to oil," Sanchez-Dahl says. "We are more active in the PDVSA complex versus the Republic of Venezuela, as we are constructive on the global energy sector – crude, natural gas and coal."

Sanchez-Dahl reports more tolerance for high-yield sovereigns. His shop is overweight on Latin America as a region and counts Colombia, Peru and Uruguay among the best performing sovereign bonds in its portfolio.

Volatility Ahead

Venezuela, with elections scheduled for October, is a reminder of the political risk that still looms in parts of the region. Potentially difficult leadership transitions and the ever-present bugaboo of inflation, were the main concerns from inside the region on investors’ minds in the early part of the year. External events that could jolt risk appetite are a consideration as well, but don’t appear to be anyone’s base case.

The health of Venezuela’s Hugo Chávez was still in question as of late April. While a violent confrontation over succession is not the base case scenario, the country is still the region’s biggest political concern, says Igor Arsenin, head of LatAm strategy at Credit Suisse. Argentina, making noise with plans to nationalize oil producer YPF, is second.

"Argentina is falling into a populist import-substitution model and I think it will backfire very quickly, and the government will probably backtrack and try to recover," Arsenin says.

Mexico’s election has not concerned investors, and the consensus view is that the July poll, seen bringing a change of leadership, is an opportunity. The rest of the region is in a much better position, though Brazil could face difficulties as it battles inflation.

At the margin, some governments may opt for slightly higher inflation compared to, say, five years ago, but Silvani says he does not see this as a major concern when most of the world continues its deleveraging process. However, if inflation expectations were to abruptly jump, then he would expect both the market and governments to react to it, he adds. In general, Latin America has done a good job to gain credibility on inflation and macro policies, and the result has been well-behaved inflation expectations.  

"Inflation is running higher than we would like in several countries, which makes inflation-linked bonds attractive in certain markets," Antin says.

Externally, the threats remain the same, even if a major market-moving event is unlikely. Investors are keeping a close eye on the leadership transition in China, and elections in France and the US. The next big set of risks, investors explain, will be more about socio-political concerns as more and more governments need to embark on fiscal austerity at a time when unemployment rates are rising and people are hurting.

Latin America continues to offer a clear contrast to the developed world, with significant momentum in terms of growth and experience, Sanchez-Dahl says.

"The base-case scenario doesn’t look bad," Arsenin says. Europe has figured out how to stabilize itself, though there could be hiccups, and the US recovery, though small, appeared to be plodding along. With the US Fed wanting to keep rates low until 2014, central banks and the market are keeping a close eye on rate developments.

Abad says his shop remains constructive on prospects for LatAm high-yield in the long term, but doesn’t discount the possibility that 2012 will end as another challenging year despite what’s been a very positive start for the markets to date. He sees a continuing strong technical bid for higher-yielding, quality assets in EM, translating into more investor demand for the credits that are best positioned to continue deleveraging, that have the balance sheet strength to weather external shocks, and which can rely on existing sources of liquidity to meet obligations. A major concern remains on the state of global growth and, indirectly, commodities.

"Our base case remains a still fragile recovery, but recovery nonetheless," Abad says. LF

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