Emerging Market Corporate Bonds

The programme of the United States Federal Reserve known as QE2 had and most likely will have many unfortunate and unintended consequences. The idea behind QE2 was that it was supposed to drive US interest rates so low that investors would seek higher yields by investing in riskier assets. In this area it did accomplish its goal. With interest rates for US government and corporate bonds at all time lows, investors went looking for higher yields. No doubt the Federal Reserve thought that investors would confine their search to the United States. They were wrong. They didn’t. In a globalised world, they looked everywhere, often in all the wrong places.

In the search for yield many investors looking for good fixed income investments looked to emerging markets. The marketing men and women on Wall Street sold these products as offering strong performance, high yields and low risk. Since many emerging markets have lower debt, faster growing economies and younger more productive populations it seemed like a no brainer.

Although these arguments applied only to countries and not to companies, some financial advisors didn’t really trust emerging market governments. According to one, “I think people are probably giving emerging market governments too much credence in their ability to manage their way through potential financial crises. I would still much rather invest with high quality emerging market companies and their management than with the politicians of certain emerging market countries.”

With such faith and with risks mounting for government bonds rising in developed markets, emerging markets countries and corporations were able to issue more debt than ever before. In 2010 they issued $151 billion in dollar denominated debt, more than in any other year.

China was a particularly preferred destination for yield seeking investors. In 2010 Chinese companies raised three times more money from bonds as they did from equities. The sales continued to break records this year. Chinese corporate yuan denominated bond sales totaled over the 100 billion yuan mark ($15.2 billion) up 60 per cent over 2010. Dollar denominated bonds did even better. Chinese companies also broke records with sales of $33 billion. Chinese real estate developers alone have sold more than $19 billion in recent years.

Now many of these bonds are beginning to go bad. The Chinese property developers are some of the first to go. Many took on enormous debt to take advantage of the real estate boom. In the past month alone prices for these bonds have fallen 22 cents on the dollar as default risks rise.

In the past, Chinese state banks would sometimes step in and buy foreign bonds. For example Greentown China Holdings Ltd. avoided a default in 2009 by paying off $400 million of foreign bonds. They raised money through lightly regulated Chinese trust companies. This exit strategy is probably closed. China's banking regulator has been cracking down on trust companies loans specifically loans to Greentown.

The foreign bond holders of Greentown were lucky to receive their investments back. The investors in Asia Aluminum were not. Asia’s largest manufacturer of aluminum extruded products paid only 20 cents on the dollar for the senior bonds and only one cent on the dollar for the $800 million worth of junior bonds. An attempt by a Hong Kong bankruptcy court to liquidate the company’s assets to get a better deal failed.

The problems are not just limited to China. Some Russian bond holders are beginning to worry. This year the Russian rouble was the fourth best performer against the dollar. The combination of high yields and potential currency appreciation was irresistible. Many local Russian companies were happy to take advantage of this opportunity to issue international bonds denominated in roubles. It sounds like a good idea unless problems develop. The market is illiquid, shallow and new, so it will be more vulnerable to sell-offs than the dollar-denominated or local rouble bond markets.

The potential for trouble came in the recent example of the Bank of Moscow. The Bank of Moscow is Russia's fifth-biggest bank whose shareholders include Goldman Sachs and Credit Suisse. VTB, the state-controlled lender and Russia's second-largest bank recently bought 46.5 per cent of the bank. What it found on the bank’s books caused a scandal. There was a $14 billion hole in its balance sheet and questionable loans worth billions of dollars to businesses related to Bank of Moscow’s senior managers. This was bad enough. The real problem was that not only were the Bank of Moscow’s $2 billion in foreign currency bonds placed in question, but also $8 billion of VTB’s own foreign currency bonds.

Many of the larger corporations in emerging markets are either state owned or have close ties to the government, which may not favor bond holders. Stiffing foreigners in pursuit of domestic policy goals is a time-honored practice.

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