When the Chinese e-commerce company Alibaba made its first foray into the capital markets in November, it could have sold its $8 billion (Dh29.4 billion) in dollar-denominated bond seven times over, such was the level of demand. To some, the deal’s overwhelming success was yet more evidence of the advances made by the emerging world’s corporate bond market.
To others, it was a sign that an asset bubble was forming. The sceptics’ voices have since grown louder. But their thesis is not necessarily stronger.
The doubters have accumulated a list of worries. A rising dollar, prospective increases in US interest rates and the scandal engulfing Brazilian oil giant Petrobras each threaten to make life less comfortable for corporate borrowers across the developing world. An additional concern is the rate at which Latin American and Asian companies in particular have loaded up on dollar debt.
Since 2000, the volume of dollar denominated liabilities in emerging markets has doubled to $4.5 trillion, thanks in part to increased corporate borrowing in these regions.
Look more closely, however and the investment climate is not as hazardous as it seems. For one thing, the assumption that corporate borrowers in the emerging world will fall victim to lopsided balance-sheets — a mismatch of liabilities denominated in dollars and revenues and assets largely in local currency — is an oversimplification.
Weak domestic currencies do not automatically mean corporate finances become precarious. A large number of EM companies actually benefit from a rising dollar. Asian-based firms, who make up a large portion of the emerging bond market, look especially well placed.
Recent research shows that while some 22 per cent of their debt is denominated in dollar, so too are 21 per cent of their earnings.
More broadly, companies operating in mining, sugar, beef, pulp and paper generate revenues in dollar but have a cost base which is largely in local currency. For these firms, a rising USD may lead to higher profit margins.
But even those whose revenues are primarily in local currency will not necessarily find it tougher to honour their debts. Most emerging market companies that tap the dollar bond market are investment-grade.
This means many operate — and have benefited from — conservative and transparent currency hedging policies. What is more, a large number of the firms we invest in are able to pass on higher debt servicing costs to their customers without suffering falls in sales.
Currency troubles aside, bond bears also point to a recent rash of corporate credit rating downgrades and defaults. Yet here too, the evidence is not universally negative. Defaults and ratings reductions have risen, but have remained concentrated within countries and industries exposed to weak commodity prices (Brazil, Russia and the energy sector).
Moreover, most of the corporate ratings cuts have been triggered by downgrades of sovereign or quasi-sovereign borrowers. In other words, many Russian corporations have been downgraded simply because Russia has been cut to junk status.
The same goes for Brazilian firms, some of whom have suffered in the wake of oil giant Petrobras’ woes. Stripping out the sovereign effect, credit rating upgrades outnumber downgrades by a ratio of 1.6 to 1. This positive rating trajectory is also borne out by credit metrics.
Emerging market corporate borrowers have a lower gross leverage ratio than their US counterparts in nearly every rating category. Partly for these reasons, default rates among emerging corporate borrowers are expected to remain at 3.9 per cent this year.
A major stress test for the asset class could well emerge when the US Federal Reserve begins raising interest rates. When that happens, corporate borrowing costs are certain to rise worldwide, particularly in the developing world.
However, the rhetoric emanating from the Fed suggests the central bank is in no hurry to raise rates. Its dot plot graph — which maps official interest rate forecasts — indicates a more gradual tightening of monetary policy than was envisaged just a few months ago. Rate rises will come but they won’t come quickly.
Also in the asset class’s favour is the stability of its investor base. Unlike other high-income bonds, emerging corporate debt is not at the mercy of unpredictable retail investment flows.
Domestic institutional investors such as sovereign wealth funds, insurance companies or pension funds currently make up two-thirds of the investor base, which has lent the market a considerable degree of stability during previous periods of market turbulence, such as the Fed-inspired “taper tantrum” in the spring and summer of 2013.
All this is not to say that investors can afford to be complacent. Business conditions are not as favourable as they have been in recent years, which means some companies could see a weakening of their credit profiles. However, with emerging corporate bonds trading at a yield spread that is more than twice that of similarly rated US counterparts, market participants appear to be sufficiently compensated for these risks.
Regarding the MENA bond market, as oil prices continue to stay low, the belief that it would have a strongly negative impact in the short term is not something which investors are concerned about.
Should the prices stay low for long, it would have an impact across the economic spectrum and may lead to concerns regarding corporate debt, should earning and profitability data trend downwards; with a potential consequence on the perception of corporate credit worthiness.
There has been an increase of new bond issues from GCC corporations in non-oil sectors as they seek to diversify their investor base. However, larger corporations have been most active in the issuance of bonds in the region, whilst only a tiny fraction of medium sized corporations have entered the bond/sukuk markets to extend their liability profiles.
The writer is Head of Emerging Corporate Bonds at Pictet Asset Management.
