From BNP Paribas via FTAlphaville:
“In our analysis, six EM sovereigns are at risk of becoming fallen angels this year or next. Three of these we consider ‘high risk’. As much as USD 259bn of sovereign and corporate bonds is at high risk of being cast down into speculative grade perdition. This accounts for 9% of all EM bonds outstanding (USD 2.87trn).
… it is little surprise that the peak of credit quality for EM appears to be over. After having hit the BBBthreshold in 2013 and improving another 1/6th of a notch over2013 (Figure 2), the credit quality of the EM benchmark has begun to slide downward. Already it has lost 1/6th of a notch and we forecast the index to slide another half notch by the year end.
The market benchmark EMBIG index achieved the coveted IG level in 2013. However, it now looks set to lose this status as soon as this year. The emerging markets benchmark index is at risk of becoming a fallen angel.
…Potentially, the 10% of outstanding EM energy corporate bonds which are rated in the BBBs (USD 192bn worth) could become ‘fallen angels’ (issuers whose lose their investment grade credit rating and slip into speculative grade). However, we believe the number of falling angels could be even higher than this, as BBB rated banks with loans concentrated in the energy sector (Figure 7) are also likely to be downgraded. Financial sector credit risks are historically the most sensitive to the EM credit cycle (Figure 8).Furthermore, the downgrading of more BBB energy-related sovereigns (Kazakhstan, Russia etc), will drag down corporate and bank ratings that are currently at the sovereign ceiling (see country titles in Figure 21).
…More recently, of the 111 net corporate downgrades in Q4 2014, half were related to issuers outside the energy sector. With USD 924bn of ‘BBB-’ and ‘BBB’ rated EM bonds outstanding (Figure 6), the threat posed by potential fallen angels is substantial.
The risk is that fallen angel events will result in forced selling by HG index investors who are typically required to unload the bonds of issuers whose credit ratings fall below the Baa3/BBBthreshold by two agencies. This will be exacerbated by the already poor liquidity environment in secondary markets, thereby threatening to create distressed situations. If fallen angel events coincide with other outflows due to expected downgrade or default fears, these distressed events could prove acute and affect even high quality liquid benchmarks as managers prioritise raising cash.
…And, given the state of the oil market and prevalence of oil-related credit among both sovereign and corporate issues where risk is concentrated at the BBB- and BBB threshold, an increase in falling angels is highly likely.
…Figure 17 lists the EM sovereigns with at least one rating in the ‘Baa/BBB’ arena and highlights the six names that we believe are at some risk of losing their IG status. Three of these we consider at high risk. Excluding Turkey, there is USD 66bn worth of sovereign debt that we consider is at risk of becoming fallen angels. USD 102bn worth of corporate bonds domiciled in these sovereigns is rated in the BBBs and is likely to also become fallen angels. This means that investors have a total of USD 168bn worth of EM sovereign and corporate debt that are only one or two notches away from potentially suffering a loss of IG status. There is a further USD 10,572mn of Ba1/BB+ corporate debt that would likely suffer downgrades were the sovereign brought down to that level. Were Moody’s or Fitch to downgrade Turkey a notch then, on top of the USD 74.6bn of sovereign debt, USD 5.5bn of IG corporate debt would become fallen angels. This would raise the total market risk to USD 259bn. This is 9% of the all EM bonds outstanding (USD 2.87trn).
Azerbaijan appears to be significantly out of step with likely downgrades.The sovereign could be rated as low as ‘Ba3/BB-’ if oil prices remain around USD 50/bbl over a three-year horizon. Risk premia should be over 100bp wider, in our opinion.
Kazakhstan may also receive a three-notch downgrade to Ba1/BB+ on the same basis as Azerbaijan.However, the market has already largely priced this in and we do not see much potential for big moves in either direction, assuming market risk sentiment does not deteriorate significantly and drag Kazakh spreads wider with it.
As with Kazakhstan, the market appears to have been overly aggressive in pricing in the downgrade potential for Russia. Spreads here are in line with B1/B+ sovereigns, whereas we expect at least a two-notch downgrade (possibly up to three notches) by the end of 2016. We question whether expectations for capital outflows to continue at the same pace as H2 2014 are valid, since much of the ‘hot money’ has probably already exited. Still, given the demand problems and other issues affecting Russian risk premia, we see only 17bp of compression potential assuming no deterioration in market sentiment. That is to say, we expect Russia to trade more like a Ba2/BB or even Ba3/BB- sovereign (during distressed market conditions) for some time. However, the occasions of prior sovereign fallen angel events (Figure 15) show that, in most cases, spreads continued to widen out one month after the first event (“t+1”). In some cases (Macedonia 2009, Latvia 2009, Slovenia 2013 and Peru 2002), spreads tightened considerably in the month following their loss of IG status. However, almost all of these (excepting Slovenia’s case) coincided with strong market rallies.
We see a moderate risk of another downgrade (Moody’s most likely), for Bulgaria. The market is not pricing in any such risk. 25bp of additional risk premia is warranted.
In the case of South Africa, there is a moderate-to-high likelihood the sovereign will lose its IG rating by 2016. Although the reduction in energy costs reduces the country’s import bill, reserves are too low, leaving the country prone to external shocks. Furthermore, the deterioration of political risks, rolling blackouts and likely bailout bill for Eskom, which will raise fiscal risks significantly, are negative factors which will not disappear anytime soon. Given the positive impact of declining oil prices on Turkey’s inflation and current account balance, we believe the threat of another agency matching S&P’s speculative grade rating has declined considerably, as we explained in our 31 October 2014 oil shock report. Tightening over the past week has brought the sovereign closer to ‘fair value’ levels. Although, were no downgrade to manifest, we would see a further 16bp of compression potential.
Nobody should be surprised by this. As US dollars flow out of emerging markets because the US is considered headed into a tightening cycle, and China is restructuring to slower and less commodity-intensive growth, emerging markets capital spreads begin to widen on capital outflow. The effect has a double whammy if the bonds are priced in US dollars, rendering coupons more expensive in local currency.
We’ve already seen several convulsions in this process in taper tantrums one and two (the second of which is still running in commodities).
Probably the only way to reverse this trend is for the US Fed and China to hang u-turns. The former may be ultimately forced to given these days EMs account for half of world GDP in PPP terms and commodity deflation is already triggering real deflation fears. The latter will cause structural disruption for EMs as it transitions to higher-value growth and consumption. EM’s with low cost manufacturing will be able steal market share from China while others with the seeds of higher-value sectors in place will benefit from rising exports to the Chinese middle classes.
It must also be remembered that the BNP figures are only the explicit dollar-denominated debts of EMs. There is a lot more shadow debt hidden on corporate balance sheets in international subsidiaries. There’s no doubt Borat debt is a looming problem, the only question is are the fallen angels as a group large enough to become globally disruptive. The answer is probably yes.
