Many emerging market companies are showing signs of vulnerability as circa USD400 Million in debt maturities come due in 2024. The big problem for these companies is the increase in the cost of borrowing as interest rates have hit heights not seen since the global financial crisis of 2007 – 2009. Companies whose jurisdiction reside in developing countries have so far only managed to rollover 10% of what they need, as they see yields on US Treasuries hit a fifteen-year high and borrowing costs going through the roof. 2024 may only be the beginning for these emerging market companies as 2025 will herald USD300 Million worth of bonds maturing.
Experts from the world of emerging market finance suggest that the situation regarding refinancing of these bonds will only get harder and harder the longer the current interest rates remain at their peak. For some companies who are regarded as being of higher quality they will probably get away with paying higher interest rates for refinancing, but for those considered to be of a lower quality their problems may be manifold. These lower quality companies may not be able to find refinancing deals which could lead to defaults and in the more extreme cases bankruptcies. This has been reflected in emerging market junk bonds (EM bonds), which has seen the average yield jump to circa 12% over the last 24 months.
Analysts in this sector of EM junk bonds suggest that the market remains extremely vulnerable especially where companies are domiciled in Ukraine, China, Brazil, Argentina, Colombia and even Dubai. For example, in September of this year in Dubai, Shelf Drilling Holdings Ltd, put a refinancing package together whereby they sold USD1.1 Billion of corporate bonds at the highest yield ever offered of 10.15%. Meanwhile back in June of this year in Colombia, Ecopetrol SA’s refinancing package of USD1.5 Billion had to pay an increase of 4% to 8.65% and 9% compared to 4.65% and 5% two years ago.
In 2023, corporates in emerging markets have so far this year managed to default on USD26 Billion of outstanding debt, and according to recently released data, this takes the total amount of missed repayments during the current rate hikes by the Federal Reserve to circa USD80 Billion. This is a massive increase over the last three years where defaults in the sector of the market in 2020 were USD9.5 Billion and USD9.3 Billion in in 2021. Experts suggest that the market has reached a point where funding allocations to those companies with a B rating or less should be reduced.
In the distressed world investors can usually pick up bargains but such is the nature of this market even they are becoming more wary. Some traders considered to be experts in this arena have been disappointed this year as they have placed bets on emerging market debt distress to ease this year, which would have led to bond gains. Indeed, investors are being pushed to borrow less in the primary market for hard currency, because the Bloomberg EM USD Aggregate Corporate Index* gave a total loss to money managers of 0.6% this year, compared to a similar gauge of US high-yield company debt which showed a gain of 4.3%.
*Bloomberg EM USD Aggregate Corporate Index – The MENA(middle east and north Africa) Bond Index follows the flagship Emerging Markets USD Aggregate index rules and applies additional country constraints. The index includes fixed and floating-rate US Dollar denominated debt issued by sovereign, quasi-sovereign and corporate issuers.
Over the next two years only USD110 Billion of junk rated emerging market bonds are coming due as the remaining outstanding bond issues are considered to be of investment grade calibre. This is the area where most experts feel that problems with refinancing, defaults and perhaps bankruptcies will occur. Such high-yield companies in 2023 have found refinancing particularly difficult with only a combined amount reaching the USD11 Billion mark compared with 2021 where a total of USD 75 Billion was reached in the refinancing arena. Portfolio managers are becoming increasingly selective, and as those weaker companies drop out, those companies with strong management will tend to be picked, especially those that can mange eventual slippage in fundamentals*.
*Slippage in fundamentals – essentially slippage is the difference between the expected price of a trade and the price at which the trade is executed. Fundamentals refer to the primary characteristics and financial data necessary to determine the stability and health of an asset. The data can include large scale or macroeconomic factors and small-scale or microeconomic factors to set a value on business or securities.
The heightened tension in the middle east is not helping matters, and as 2023 approaches its end companies considered riskier than others will not only find their window for debt sales dwindling but competition between the issuing parties becoming fiercer and fiercer. However, as access to dollar funding and indeed euro-funding dries up, experts suggest that the lower rated companies can access bank loans to overcome any financial short-comings or even turn to local currency bonds. They may even access their local markets or loan markets for refinancing or in a last-ditch attempt turn to assets sales.
The current future for interest rates remains on hold as the ECB (European Central Bank), the Bank of England and the Federal Reserve have all kept interest rates at their current level. At the MPC (monetary policy committee) meeting at the Bank of England held last Thursday 2nd November 2023, it was announced that a restrictive policy stance would be needed for an extended period of time to curb Britain’s rate of inflation. In Athens on October 26th, 2023, the European Central Bank left interest rates unchanged after an unprecedented streak (10) of interest rate rises. It was also announced that the rising market talk of interest rate cuts was premature. Finally in the United States, again on the 2nd of November 2023 the Federal Reserve announced that it would keep Overnight Federal Funds steady, which is the second consecutive meeting where they have kept the status quo. However, the chairman of the Federal Reserve Jerome Powell made it very clear that if data shows the slow decline of inflation has stalled, they reserve the right to increase rates despite market predictions of a cut or that we have seen the last of the tightening cycle. Emerging market companies whose junk bond issues are coming due late 2024 and 2025 can only hope that interest rates have dropped significantly by the time their debt matures.
Despite the risks prevailing in the emerging markets bond markets, as highlighted above, many experts suggest that emerging market equities, as opposed to the developed markets, are in line from improving economic growth driven primarily information technology companies and emerging Asia. Interestingly for Q1, Q2 and Q3 of 2023 small cap securities
(MSCI EM Small Cap Index*) have outperformed large cap developed market by 13.7% and over Q3 by 2.9% led by industrials, information technology and materials particularly across South Korea, India and Taiwan.
*MSCI EM Small Cap Index – is a leading provider of critical decision support tools and services for the global investment community. This index includes representation across 24 emerging market countries and has 1,978 constituents. The index covers circa 14% of the free float adjusted market capitalisation** in each country. The small cap segment tends to capture more local economic and sector characteristics relative to larger emerging market capitalisation segments.
**Free Float Adjusted Market Capitalisation – The standard calculation for determining market capitalisation is the total number of outstanding shares including those both publicly and privately held. However, in free float market capitalisation the valuation of the company relies on just the outstanding shares held publicly.
Furthermore, in terms of growth, emerging markets have, on a consistent basis, outpaced their developed counterparts, which is mainly due to robust capital investments and youthful demographics. Experts predict that as recession clouds envelope the United States, Great Britain and Europe, growth differential is expected to widen further and be at its highest level since 2013. Analysts are saying that 2024 will see emerging markets becoming the growth engines of the world with economies in Africa, Central Asia and the Middle East showing remarkable resilience. They go on to conclude that emerging market bonds (despite the potential current crisis) continue to hold promise, and therefore could represent an attractive investment, but a rational approach needs to be taken with sensible choices which could reap good rewards for the sensible investor.
Returning to the EM bond arena, again analysts suggest that credit-rating agencies and money managers believe the situation with emerging market junk bonds will become more complex the longer interest rates remain high. In this challenging environment, external debt cash flows from emerging markers become significant especially over the next couple of years as a number of borrowers could well struggle to refinance at rates considered sustainable in the international bond markets in the higher for longer US Treasury yield arena. So, whilst experts are predicting sustainable growth in emerging markets, traders and money managers will be keeping a weathered eye on issuers, where they are domiciled and the markets they represent therefore making diligent company and country selections.