Last year was one of the most successful for international bond investors in many years, but that that is starting to change as the end of quantitative easing (QE) is already apparent and political risks are rising for issuers like Russia.
The systematic winding down of QE programmes by global regulators hasn’t been able to change investors’ positive attitude towards emerging markets (EM) assets. That was driven by the macroeconomic backdrop and the high-risk appetite on the part of investors thanks to the low yield environment, which combined to create record breaking activity in the Eurobonds primary markets.
Despite this, since the start of 2018 the game has begun to change. The growth of the yields in the US and a revaluation of credit risk premiums has offset the ongoing economic growth in emerging markets. Volatility is on the rise again, but activity in the primary market has remained at a high level. All taken together that means the windows of opportunity for issuers are starting to narrow.
The end of QE
Excessive liquidity has been driving the growth of EMs in the last few years. Investors from developed markets in search of yield willingly took on extra credit risks. In spite of the intentions to withdraw, regulators were in no hurry to hike rates and bring QE to an end. At the European Central Bank (ECB), Bank of England and Bank of Japan interest rates remained at their historical low and large asset purchase programmes continue. Only the US Federal Reserve has been gradually changing its monetary policy. The US regulator increased the federal funds rate three times in 2017, and from October it also started a programme to wind down its position in the bond market, reducing its securities portfolio.
However, the Fed’s actions have not impacted the markets yet because of the slow place of the change. Market participants were not interested in the tightening of monetary policy as such, but in how quickly it would be implemented.
Dynamics of FRS rate, 3M LIBOR USD and UST 10Y YTM, %
The recent US tax reform launched by the Trump administration doubled the country’s budget deficit in 2018, which led the US Treasury Department to enter the market with a record borrowing plan. And the increase in the offer of treasury securities at weekly auctions has led to a significant withdrawal of dollar liquidity from the market.
Since the start of this year the Fed has continued to tighten monetary policy. The federal funds rate was raised in March and may be raised two or three more times during the year, leading to rapid growth in US treasury securities yields. The yields on the ten-year Treasury bills (UST 10Y) have risen to a ten year high of almost 3%.
Rising borrowing costs and falling liquidity are reflected in the rates being charged on the interbank market: the three month Libor USD rate has grown by 62bp since the beginning of the year and reached 2.32% in April. These facts indicate that the QE era for the dollar seems is coming to an end.
While QE winds down in the US, the Europeans are further behind. The ECB announced last year that its €30bn a month asset purchase programme would continue until September 2018.
It is unlikely that the ECB, Bank of England or Bank of Japan will raise rates anytime soon. Excessive liquidity from Europe and Japan continues to support debt markets. However, it is already apparent that current market conditions are drastically different this year from those in previous years.
A “new normal” is gradually asserting itself in the international capital markets.
The increase in US Treasury securities yields has led to an overestimation of the attractiveness of premiums by investors in emerging markets. This has resulted in the increase in the capital flow into dollar bonds with higher credit quality, which has started to provide conservative investors with an acceptable level of yields. That could be bad news for EM investors and issuers. According to the Institute of International Finance (IIF), net capital outflow from EM assets-oriented funds amounted to $4.5bn billion in February alone.
Dynamics of yields to maturity of EM sovereign Eurobonds, Euro–Cbonds indices, %
Despite an upbeat macroeconomic story in EMs, the falling demand for their Eurobonds is driving up the yields of Eurobonds in emerging markets.
The yields of sovereign Eurobonds from Eastern Europe have grown by 64bp since the beginning of the year, from Africa by 49 bp, and from Asia by 44 bp. JPMorgan’s global EM bond (TR) index has decreased by 2.3% this year after the total yield grew by 9.1% in 2017.
Falling demand will put more pressure on the market as a significant volume of bonds mature in the mid-term and will be more difficult to refinance.
The volume of debt obligations that must be repaid in the course of just the next two years amounts to $513bn. Issuers will be forced to enter the market with new issues to refinance outstanding debts.
Due to the decrease in demand for new issues these will have to be issued at a premium to the prevailing market rates. Thus, in the foreseeable future we may see Eurobonds yields in EMs continue to grow, while at the same time the level of activity in the primary market will remain high.
Planned EM Eurobonds repayments
Russia back to investment grade
Russia is in a stronger position than most in the more demanding market.
In February, international ratings agency Standard & Poor’s (S&P) rating agency raised Russia’s foreign currency credit rating to BBB-, returning the issuer to an investment grade rating.
Russia was rewarded for its conservative fiscal policy, low debt-to-GDP ratio as well as copious foreign currency reserves that topped $457bn at the start of April.
The investment grade credit rating significantly increases the number of potential investors. Experts estimate potential passive capital inflow to Russia’s Eurobonds could be $2bn as a result of the upgrade in the short term. Increasing demand should lead to a decrease in yields, which will only encourage the Russian Ministry of Finance to issue more bonds.
Against this, Russia remains vulnerable to political risks, which have rapidly escalated in the last few months. In March, the British government announced it was mulling imposing restrictions on trading Russia’s debt securities on the London Stock Exchange and banning the clearing companies Euroclear and Clearstream from working with Russia’s Eurobonds. No decision was made in the end, but these fears are still lingering in the background.
In the middle of March in the midst of the scandal that followed the poisoning of the former spy Sergei Skripal, Russia’s Ministry of Finance hurried to enter the market with new Eurobonds issues.
The issue was released in two tranches: in the form of a new Eurobond issue worth $1.5bn maturing in 2029 and a tap issue for Russia 2047 worth $2.5bn. In spite of the market volatility, new issues were met with high demand and the order book was twice over-subscribed. In total, the demand for two tranches amounted to $7.5bn, and institutional investors from the UK and the US were the main investors.
But despite the strong demand the issue cannot be called a success as it was bought at the cost of offering investors large premiums.
The initial target yield for the Russia 2029 bond was 4.75%, and for the tap issue Russia 2047 it was 5.5%. After pricing, the bonds were issued at 4.625% and 5.25% respectively. And as the political tensions continue to rise so will the yields on Russia’s sovereign debt.
By April similar risks of sanctioning Russia’s debt appeared in the US, and new sanctions were imposed on big Russian companies, with major aluminium producer Rusal singled out. Rusal’s Eurobonds have been badly affected by the harsh new sanctions and lost a lot of their value. These events discourage major investors from any long-term investments into Russian debt and Russian corporate borrowers due to the new levels of uncertainty that prevail in the market. The rationale for singling out some companies and people on the last sanctions list is not clear, raising the possibility that any company could be targeted next, thus increasing the risk for all Russian assets.
Taken all together, the heightened political risks associated with Russian debt and the rising US T-bill yields present a serious challenge to the international Eurobond markets.
A large volume of repayments due over the next few years will drive up the premiums issuers will need to offer if they want to refinance, and force issuers to enter the market with new issues in order to refinance the current debt. At the same time, the outflow of capital from emerging markets will inevitably lead to an increase in yields and premiums for new issues and could lead to increasing difficulties in servicing existing debt.
The ratio of probability of default to yield to maturity of 10-year Eurobonds of sovereign EM issuers