Is Corporate Debt A Ticking Time Bomb In Latin America?
In a report published on July 20, Moody’s Investors Service warned about growing indebtedness in the world’s emerging markets, noting that in Latin America the ratio of external debt to Gross Domestic Product was 48%, in line with the 47% ratio in the Asia-Pacific region.
Moody’s report notes that companies and governments in emerging markets increased their debt issues in recent years because of the low cost of credit, and their external debt shot up to $8.2 billion in 2015, compared with only $3 billion in 2005. “External vulnerability has increased significantly in about 75% of the emerging economies around the world,” the report says. The boom in indebtedness has been produced largely in the private sector, where external debt has increased by 14.3% since 2015, compared with 5.9% in the public sector. In Latin America as a whole, Moody’s stressed, this pattern of growing debt has been most notable in Brazil and Mexico. Brazil’s rate of debt growth has been the highest in the region as a whole, reaching 38% of that country’s GDP in 2015, compared with 22% a decade earlier.
For investors, dollar-denominated debt issued by firms in riskier and less-developed countries has been one of the most profitable investments, with returns averaging more than 11%, according to the JPMorgan Emerging Markets Corporate Debt Fund, the CEMBI Broad. For their part, American companies with debt rated “investment quality” have provided an average return of only 3.3%. Meanwhile, equivalent debt denominated in British pounds sterling has averaged 1.8%, and debt denominated in euros has offered even lower returns.
[drizzle]No wonder so many investors have opted to take their money out of fixed income markets in the world’s largest economies and have reinvested it into emerging market debt. Over the past six months alone, some $18 billion has been invested in emerging debt funds, according to Bank of America Merrill Lynch. “In a low-interest rate environment, when rates are generally low around the globe, and there are negative interest rates in many parts of the developed world, the tendency for human beings is go and look for yield in riskier parts of the planet,” notes John Bates, emerging market corporate analyst at PineBridge Investments in London, which manages funds worth about $81 billion. “When you look at pension funds and insurance fund investments – their mantra is generally a very conservative goal or mandate in terms of what they are trying to invest in. But obviously with the lower interest rate environment, the tendency is to step away from the very safest investments and look into areas that are slightly more high-yielding, or relatively high-yielding.”
Bates worries that some investors who have little or no experience in emerging market bonds may be taking on more risk than they should. “These are tourists with very fat pockets,” Bates told Reuters in an earlier interview. “Typically, emerging market debt is a small allocation within a big pension fund or asset allocator, so if you get a big fund dipping into that pool, then removing that money there could [create] some very severe repercussions.”
Emerging market corporate bond markets may be seeing an “investment balloon effect,” he says. “This hunt for yields is driving spreads tighter, and it is pretty indiscriminate, and even heavier the further down the credit spectrum you go.” Over the past few months, Bates adds, “we’ve seen the dynamic where the fundamental picture in emerging markets is relatively stable, but we’ve seen valuations tightening a lot. The emerging market world has become a lot more expensive, and it’s not really because the fundamentals have gotten any better but because of the technical factors of investors chasing high yields.”
“With the lower interest rate environment, the tendency is to step away from the very safest investments.” –John Bates
According to Bates, it is “really interesting” that in the emerging market corporate world, the investible universe is actually decreasing. In 2016, “we’ve seen a record number of calls and tenders and buybacks from corporate issues. [Thus, companies] are actually using the low interest-rate environment to refinance their debt. Forty percent of the Latin American issuance has been alongside buybacks, so the net effect of that is actually no increase in the investible universe in bonds.”
For example, in Latin America, adds Bates, Pemex, the Mexican state oil firm, “has issued a substantial amount of bonds right across their credit curve, but they also announced that they were repurchasing a lot of bonds as well. Pemex’s new issues, which are at lower rates, and slightly longer duration, are paying for bonds Pemex issued three or four years ago at higher rates and shorter duration. The risk there is that if we move into an environment where we have higher interest rates, it could mean that other asset classes become more attractive again, and then you have lots of people trying to get out of [this] asset class.”
Corporate Debt – The Risks in Latin America
According to Juan Gabriel Fernandez, executive director of the Center for Financial Studies at ESE, the Business School of the Universidad de los Andes in Santiago, Chile, “Whenever you evaluate risk in these situations, there is always the possibility of a bubble.” Nevertheless, considering the data available at the moment, he does not believe that this is the case in Latin America. “You don’t see megaprojects of dubious financial profitability in this flow, nor is there evidence of a great mismatch of currencies in order to take advantage of the conditions of indebtedness — which could possibility lead to an additional risk of reconnecting in the future. Currently, there does not seem to be any situation we could call a bubble,” he says.
Bates notes that there are “two kinds of main external threats that can happen in Latin America.” The first category is exemplified by the recent Brazilian banking crisis, in which the sector was heavily exposed to real estate projects and large-scale megaprojects that were “left in the lurch when banks were left without liquidity to fund them…. That sort of real estate bubble is not as likely now,” he adds. “We’ve just been through the Brazilian ‘car wash’ scandal, and the economy looks to have stabilized a lot. There are quite a few reforms,” and the issue of the impeachment of President Dilma Rousseff appears to be near its resolution. “So I think that the market looks to be a lot better placed to deal with lower interest rates at the moment.”
The other threat involves currencies, Bates points out. “Emerging market currency is a key component, particularly in the dollar-denominated debt markets. Traditionally, Latin American companies have only been able to borrow in decent amounts of money short-term and at relatively high interest rates. This is why the U.S. dollar-denominated market really took off, and it suited a lot of large Latin American companies, particularly the Mexicans, because they had significant exports into the U.S., and therefore they had U.S. dollar revenue streams which they could match against their dollar-denominated debt. One of the mismatches in currencies that has happened in the