Default Risks Could Sour Demand for Emerging Corporate Debt

More emerging market companies are likely to default as the world economy slows and Western banks rein in lending, a risk that is unnerving investors who were snapping up their debt just a year ago.

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Emerging market corporate bonds were the top pick for yield-hungry funds in early 2011, encouraged by firms' strong balance sheets and relatively buoyant growth in domestic demand for consumer goods and financial services within emerging economies.

As a result, emerging corporate bond issuance reached more than $180 billion last year, just shy of 2010's record levels, according to data compiled by ING.

But appetite for the sector faded in the closing months of the year as the euro zone sovereign debt crisis squeezed confidence from global capital markets and fears mounted about the impact of deleveraging by euro zone banks.

This year also started off on a sour note, with the default last week of Kazakh sovereign wealth fund-run BTA bank, which could trigger demands for early repayment of up to $8 billion in debt - a huge sum in the emerging corporate debt sphere.

Other flashpoints for investors include China-focused company Sino-Forest, which missed a coupon payment on its debt late last year, while Fitch last week placed Turkey's Calik Holdings on watch due to refinancing concerns.

Following state-owned Dubai World's debt standstill in November 2009, Dubai faces $15 billion in maturing bonds and loans this year, according to the IMF . It may be difficult for government entities to find the cash without recourse to the emirate or neighboring Abu Dhabi, analysts say.

With the euro zone crisis still unresolved, investors are also fretting about politics, with elections in a number of key countries, and the possibility of a hard landing in China.

"The year ahead appears to be laden with a number of risks," David Spegel, global head of emerging markets strategy at ING told investors this week.

"If borrowing costs remain ... higher, we might have to expect long-term default rates for corporates to be adjusted slightly higher and perhaps for us to see more frequent defaults."

ING reckons default rates for emerging markets companies will peak at just over 2 percent in August before easing, compared with less than 1 percent at the end of last year.

But in the bank's worst case scenario, in which all emerging corporate bonds which have traded at 65 cents on the dollar or below in the last three months default, the rate would jump above 8 percent by the end of the year.

JPMorgan sees a default rate close to 6 percent this year, having revised its estimate upwards following the BTA default.

That compares with defaults of over 10 percent in 2009 after the collapse of Lehman Brothers.

The gloomy outlook mirrors that in developed Europe's corporate sector.

According to ratings agency Standard & Poor's, the western European speculative-grade default rate will increase this year to 6.1 percent, from 4.8 percent at the end of the fourth quarter of 2011, and could rise to as much as 8.4 percent.

Investors seeking to escape the worst effects of the euro zone crisis, which is also hitting central and eastern European economies for which the bloc is a key export market, currently favor Latin American and Asian corporates ahead of those from Europe, Middle East and Africa (EMEA).

But default risks are not confined to Europe.

Polina Kurdyavko, corporate fund manager at BlueBay Asset Management, expects seven defaults this year among 450 companies she looks at, including three in Indonesia, three in China and one in the Middle East.

With returns last year having disappointed many investors' expectations that they would outperform emerging sovereign and U.S. high-yield markets, emerging corporates may also have to pay more for their money. The benchmark emerging markets corporate bond index returned just 3 percent in 2011, compared to 7 percent for U.S. corporate bonds, according to JPMorgan.

"The market is not going to be closed but it will be more expensive for borrowers," said Kathleen Middlemiss, emerging corporate debt analyst at UBS.

"Returns will not be stellar this year."

CONTAGION RISK

Individual corporate defaults are likely to affect similar borrowers' ability to raise funds.

BTA's default has hit the debt of other Kazakh banks such as Kazkommertsbank, and even tempered gains in state-owned entities such as Kazmunaigas, given the large stake held in BTA by sovereign wealth fund Samruk-Kazyna. Kazakhstan has accounted for the largest share of emerging market corporate defaults in the last five years, ING said in a recent client note.

"The issue of Kazakhstan is political risk," Kurdyavko at BlueBay told investors this week.

"It's the only risk you cannot quantify, that's why for the best part of three years we haven't invested in any Kazakh deal."

GLIMMERS ON HORIZON

The market for corporate borrowers remains open, however, with Russian bank Sberbank holding roadshows this week for a Eurobond, and Latin American borrowers Pemex and Petrobras issuing well-received bonds this month.

And if emerging market companies, particularly in Europe, cannot get loans from western banks, more of them may seek to raise funds by selling bonds. Banks are still estimating emerging corporate issuance this year of close to $200 billion.

"As developed markets are contracting, how many loans are going to be rolled over?" said Spegel, noting that lending constraints during the sub-prime crisis had encouraged U.S. corporates to issue bonds instead.

"We might see the same occur in the CIS, eastern Europe and possibly the Middle East."