Outlook 2018: Emerging markets issuance to remain strong but tempered by rates, elections

By Rebecca Melvin

New York, Dec. 29 – Many expect bond issuance from emerging markets in 2018 to remain high but not as high as last year since many funding needs were taken care of as issuers looked forward to 2018’s potentially higher rate environment and active presidential elections calendar.

“It was expected that interest rates were going up, and there was something of a rush to get things done,” one market source said regarding Latin America’s 2017 primary market.

Issuance for that region was remarkably high at $147 billion for corporate and sovereign issuance combined in 2017, and up 15% for the year. The cash value of these deals was about $143.8 billion, a New York-based market source said.

But that trend is expected to be curtailed, especially on the sovereign side, by a full calendar of presidential elections, including Colombia in May, Mexico in July and Brazil in October.

“Sovereign issuers are slower to issue when a change of government occurs. And a lot of those sovereign issuers don’t need to issue because they have already taken care of 2018 needs. A lot of issuance comes from sovereign and quasi sovereign still run by a sovereign sector,” the market source said of Latin America.

Meanwhile, the Gulf Cooperation Council of Arab Gulf states issued a heavy $50 billion in new notes in 2017, accounting for fully one-third of emerging market sovereign issuance, which signals potentially lower need this year. That combined with higher oil prices might mean fewer issues. But it may go down only at the margin as most oil exporting sovereigns look to cut local currency issuance rather than hard currency issuance on any fiscal consolidation, according to Morgan Stanley Research.

Its expectation is for still high net issuance for 2018, and that will be an additional reason why spreads will only slightly tighten in the first half of 2018, Morgan Stanley said in its outlook report entitled, EM-bracing a Bullish 1H18.

Issuance in 2017 was high and a main driver in preventing spreads from tightening further despite record inflows into the asset class, the report noted.

Moderating issuance eyed

In total, emerging market debt issuance in 2017 was about $600 billion, running at a record level given easy money conditions. But conditions are pointing to moderating issuance in 2018, analyst Kay C. Hope of BofA Merrill Lynch agreed.

Hope does not see high issuance, particularly in Asia in 2017, weighing on the market this year, especially in the Emerging Europe, Middle East and Africa and Latin America regions.

“I’ve had people say to me how is this all going to be absorbed, but by the time you take out maturities, suddenly it’s not really going to be that difficult to absorb. It’s not really growing so quickly,” Hope, BofA Merrill Lynch’s director of corporate credit research for EEMEA, said.

Latin America performed well in 2017, accounting for 28% of emerging market corporate supply.

And contrary to Morgan Stanley’s view of ongoing strong hard-currency issuance from the Middle East, Hope thinks there will likely be fewer issues in 2018 than in 2017. “A lot of issuers were making up for lost time, and we think they are going to settle into a more typical pattern,” Hope said.

$400 billion for 2018

In all, BofA Merrill Lynch estimates $400 billion of new issuance for emerging market corporates in 2018, which is down from $452 billion in 2017 as of Dec. 8. This breaks down to $254 billion in issuance for Asian issuers and almost equal $74 billion and $79 billion of issuance in corporate EEMEA and Latin America, respectively.

The $254 billion in issuance for Asian issuers is about 60% of total volume, and compares to $286 billion of issuance from emerging Asia in 2017, or one-third of total volume.

Emerging Europe is estimated to see $74 billion in new issuance in 2018, which is down from $79 billion for 2017 through Dec. 8, and Latin America is expected to see $72 billion in new issuance, down from $87 billion in 2017, according to BofA Merrill Lynch’s outlook report, GEMs Corporate Credit Year Ahead, 2018: Tighter and Tougher.

“Big issuers have done a lot of their liability management already, so there is just less to do,” Hope said. Companies like “Petrobras and Pemex have already done a lot of that because they were looking ahead to elections and accelerated issuance because of elections,” Hope said.

Petrobras refers to Petroleo Brasileiro SA, and Pemex refers to Petroleos Mexicanos SAB de CV.

Last fall, Brazil’s Petrobras priced $2 billion of global notes in two tranches due in 2025 and 2028. The $1 billion notes due 2025 priced at par for a yield to maturity of 5.3%. And the $1 billion of bonds due 2028 priced at par for a yield to maturity of 6%. A portion of the proceeds was to refinance upcoming maturities.

Petrobras has transformed itself. “Deals that have been used to take back old bonds and trim debt don’t look particularly sexy, but overall they are far more notable transactions,” a New York-based source said of the oil and gas company.

“Over the last 10 to 24 months, Petrobras has done much better corporate finance. Previously it didn’t have any liability management; now it’s in good shape in terms of 2017 to 2020 liabilities,” a market source said.

Mexico’s Pemex priced $5 billion of senior notes in a reopening of its 2027 and 2047 securities in July. The Mexican state-owned oil company priced $2.5 billion of the 2027 notes at 105.487 to yield 5¾%. The yield printed tighter than talk at 6%; and $2.5 billion of the 2047 notes at 98.094 to yield 6.9%, which was below yield talk in the low 7% range.

The new bonds added to $3 billion of the 6½% notes, which originally priced Dec. 6, 2016, and the $2 billion of 6¾% notes, which originally priced in September 2016. Those deals are now $5.5 billion and $4.5 billion in size, respectively.

Proceeds of the new notes will be used to fund buybacks of three near-dated maturities, as well as to finance Pemex’s investment program.

EM sovereign supply to fall

An estimate on sovereign issuance, which is generally a much slimmer piece of the new issuance pie, was more difficult to predict for the coming year than corporate debt, sources said. For 2017 there were about $150 billion in new issue transactions completed.

All emerging market investment-grade issuance is expected to be down 5%, according to HSBC. “At least the high-grade space is curbing 5%, but it’s tough to tell what will happen with people prefunding liability management and elections. New issuance should be softer,” a New York-based market source said of 2018.

There will be less issuance priced by Russia compared to what comes out of that sovereign in maturities in 2018, a source said. The forecast is based on Russia’s debt curve, which is predominantly comprised of five-year paper.

In 2017 the high level of new issuance was against a backdrop of strong fundamentals and a solid technical picture. Key benchmarks outperformed while the global economy continued to heat up. Benign conditions included no volatility to speak of and a relatively weak U.S. dollar, which benefited emerging market currencies.

In addition, commodity and oil prices picked up without contributing to volatility.

Issuance from oil exporters

Despite the high level of sovereign issuance from the GCC in 2017, oil exporter issuance should only go down at the margin as most sovereigns look to cut local currency issuance rather than international issuance on any fiscal consolidation. Fiscal deficits for EM only reduce modestly and even this is likely to be reflected in lower local issuance.

Despite a rebound in oil prices in the second half, oil prices remain below fiscal breakeven for Oman, Bahrain and Saudi Arabia, the largest EM sovereign issuer in 2016 and 2017.

While oil exporters were big on the new issue scene, it continued to be Asia corporates that accounted for a lion’s share of new issuance, or $286 billion, according to BofA Merrill Lynch statistics.

“The level of debt [in China] is clearly worrying,” according to Morgan Stanley. But the bank’s view is that China will be able to navigate its challenges and continue to move toward becoming a high-income economy as it works toward ensuring sustainability of growth. “From here we think that debt and inflation dynamics will continue to improve,” according to Morgan Stanley, which believes that the pace of increase in China’s overall debt to GDP will moderate significantly.

There is also a cautious outlook regarding Turkey. Although Turkey comes from a much lower debt level compared to China, the increase in total debt is high and there is more potential for rough sledding for that sovereign. It has high short-term funding needs and is highly reliant on foreign portfolio flows. The extent of its fiscal expansion needs to be monitored, Morgan Stanley warns.

Meanwhile, Saudi Arabia had the biggest increase in U.S. dollar sovereign debt in 2017. While outright debt levels are low – its total debt is well below Turkey, South Africa and Brazil and about on par with Argentina – and its fiscal deficits are not consolidating, external funding of deficits are likely to remain high to avoid the crowding-out effect from the domestic private sector, Morgan Stanley noted.

New issuers tap market

2017 was notable in the number of new issuers that came to market, or issuers that had not been in the market for many years. The Republic of Iraq priced $1 billion of 6.752% 5.5-year notes on Aug. 2, representing the sovereign’s first international bond since 2006.

Argentina came back to the market for the first time in 15 years in April 2016, and in June 2017 it priced a $2.75 billion century bond with a 7 1/8% coupon. The bond priced at a discount to par of 90 to yield 7.917%. Argentina was able to get the large deal done, but because it was right before Argentina’s mid-term elections it had to be done cheaply. The long hiatus in accessing the capital markets came after the sovereign defaulted on $80 billion of debt in 2001.

Argentina’s Tecpetrol SA was new to the international market, pricing $500 million of five-year notes at par to yield 4 7/8% in early December.

Azul SA of Brazil priced $400 million of 5 7/8% seven-year notes at 99.294 to yield 6%, according to a market source. The notes are being issued by Azul Investments LLP and will be guaranteed by Azul and Azul Linhas Brasileiras SA.

And Mexico’s Alpha Holding SA de CV priced $300 million of five-year notes at par recently to yield 10%. Barclays, Credit Suisse and UBS were joint bookrunners of the notes, which are non-callable for two years.

Caution ahead

With the United States and European Central Bank winding down quantitative easing, or bond-buying, programs, a slew of emerging market national elections on the horizon, and uncertainty over the direction of large developed economies like the United States, issuers will find it somewhat more difficult to pull the trigger on new deals in 2018, many expect.

JPMorgan noted in is Dec. 18 weekly market recap that there will be a lot change in the Federal Reserve in 2018. With the new Fed chair taking over in February and a number of committee members rotating out of their voting positions. “We believe the Fed will be slightly more hawkish than it is now and the changing of the guard is something investors may want to watch next year,” the recap from J.P. Morgan Asset Management said.

The downtrend in credit quality troughed in 2017 and positive ratings drift is expected for the first time since 2013 on the back of improving fiscals and debt dynamics, according to Morgan Stanley Research.

“On a total return basis we expect both EM credit and EM local markets to outperform our bullish U.S. Treasury forecasts,” according to Morgan Stanley’s outlook report.

“Markets often turn on small shifts in direction,” the Morgan Stanley report said. “Our global base case is that risk will wane in the second half of 2018, but that doesn’t mean that we will see a cataclysmic unwind of EM risk.

“Still EM foreign exchange may weaken as the U.S. dollar regains strength, local market curves add or retain risk premium and EM sovereign spreads widen as U.S. corporates sell off. The risk to this base case is both on timing and magnitude.”

“Big issuers have done a lot of their liability management already, so there is just less to do.” – Kay C. Hope, BofA Merrill Lynch’s director of corporate credit research for EEMEA

“On a total return basis we expect both EM credit and EM local markets to outperform our bullish U.S. Treasury forecasts.” – Morgan Stanley in an outlook report

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