[LONDON] Emerging markets are beginning 2015 with the gravest risks threatening the asset class since the height of the financial crisis.
Headwinds range from the political and economic crises in Russia and Ukraine to troubles at Brazilian state-owned oil company Petrobras and Chinese property firm Kaisa to the slide in commodity prices generally, and oil specifically.
Then there are more technical issues that could lead to periods of volatility for emerging markets bonds, in particular rising US rates and a strong US dollar. "It's going to be one of the toughest years we've had," said one emerging markets debt capital markets banker in London.
One problem area, according to analysts, is EM corporates.
"The combination of declining commodity prices and rising sovereign risks, especially in Russia and Brazil, threatens to derail what has been a five-year-long trend of improving credit, portfolio inflows and declining credit spreads," said Citigroup analysts in a report published earlier this week entitled Not a Happy New Year for EM Corporates: Defaults Ring in 2015, and Downgrades May Be Ahead.
Aside from the slide in commodity prices, the corporate sector has already had two bruising stories to contend with in the past month.
In late November, Petrobras announced it was delaying its audited third-quarter 2014 results following the revelation of a money-laundering and corruption investigation. Petrobras is the largest bond issuer in the emerging markets.
The company's management has vowed to release the results this month. Although Petrobras bonds have rallied in the past couple of trading sessions, analysts say the company is in for a volatile ride, and that a failure to publish its results as anticipated could result in the loss of its investment-grade status.
The scandal has already claimed one victim. Construction company OAS, which is embroiled in a federal investigation over kickbacks with Petrobras, missed a US$16m coupon payment on US$400m bonds on January 2.
Fitch recently downgraded OAS by five notches to C from B+, with Moody's following suit, downgrading the credit to C from B2, citing the missed payment.
Petrobras's troubles could also weigh on the perceived creditworthiness of Brazil, whose ratings are also coming under pressure. The sovereign is rated Baa2 by Moody's with a negative outlook, BBB- by Standard & Poor's and BBB by Fitch. The last two ratings have stable outlooks.
Citi analysts say that if Brazil was to lose its investment-grade rating, it would have a cascading effect on the ratings of other state-owned companies, while financial institutions' senior ratings would be downgraded "as they cannot be rated above the sovereign."
Other companies that are at the sovereign ceiling and generate a large portion of their earnings domestically could also see their ratings come under threat.
Brazil is not the only leading emerging market sovereign whose rating is under threat of a downgrade. Russia is the most obvious candidate, and could lose its investment-grade status from Standard & Poor's. South Africa and Turkey also face potential downgrades.
The other emerging markets corporate under the microscope is Chinese property company Kaisa, which defaulted after its chairman resigned.
The resignation of Kwok Ying Shing late last month contributed to the company defaulting on a HK$400m (US$51.3 million) loan. The company also appeared to miss a US$26 million coupon payment on US dollar bonds on Thursday.
While the government has shown its support for the property sector as a whole through interest rate cuts and lowering the rate on mortgage financing, Citi analysts say "idiosyncratic risks of individual credits, some of which have been implicated in ongoing municipal corruption probes, are the main problem for debt markets." The Kaisa default pushed the high-yield part of the Chinese property sector wider by 75-100bp, with volatility likely to remain until the situation is fully resolved.
Despite all these problems, JP Morgan analysts believe its index tracking emerging markets corporates, the CEMBI Broad, will deliver a total return of 5-6 per cent in 2015 driven by a 70-90bp spread tightening. That would compare with a return of 3.6 per cent in 2014.
The US bank also thinks the EMBI Global Diversified index, which monitors hard currency sovereign debt, will return 4-6 per cent. That compares with 7.4 per cent last year.
JP Morgan's forecasts are based on assumptions that 10-year US Treasury yields will reach about 2.70 per cent by the end of the year, from 2.12 per cent as of January 5, that the spread on the Global Diversified index will reach 275-300bp, from 358bp, and that the CEMBI Broad will reach 300-325bp, from 393bp. "Hard currency returns should come from carry and spread tightening," said the bank in its 2015 outlook.
There was strong differentiation within both indices in 2014, with Venezuela and Ukraine spreads widening by nearly 1500bp but Indian and Turkish credits tightening. Investors expect differentiation to become increasingly important this year.
JP Morgan also forecasts sovereign issuance will "drop meaningfully", while corporate volumes will continue the records of recent years.
"EM sovereigns and corporates posted a record year for gross issuance in 2014, ending the year with US$92.5 billion and US$367.9 billion, respectively. For 2015, we forecast gross issuance of US$69.8 billion and US$356.8 billion, respectively, suggesting a 25 per cent decline for EM sovereigns, but roughly in-line volumes for EM corporates which should continue to be driven by Asia whereas EM Europe remains subdued."