Potential US default threatens EM investor confidence

Asia’s credit markets are at risk of losing their recently gained bond investor inflow momentum as fears of a potential US default mount.
Investors are cautious towards emerging market asset classes amid concerns over the US government shutdown and debt ceiling discussions.
Investors are cautious towards emerging market asset classes amid concerns over the US government shutdown and debt ceiling discussions.

Emerging market funds returned with a bang in September but such impetus is unlikely to continue into October as the ongoing US debt ceiling debate and fears of a default could take a toll on market sentiment, potentially prompting investor outflows.

Following inflows of $560 million into emerging markets for the week of September 23, investors withdrew a net $240 million from bond funds last week, according to EPFR data. Outflows were primarily led by local currency bond funds with $292 million, followed by hard currency bond funds with $155 million. In contrast, blended currency funds still received inflows of $217 million.

The general outflow reflects the cautious attitude of investors towards emerging market asset classes amid concerns over the US government shutdown and debt ceiling discussions, highlight experts. If the US’s dire condition persists, leading to a potential default, emerging markets could continue to see bond investor outflows in the coming weeks.

“A scenario of default or sustained debate on the US debt ceiling could derail the nascent global growth recovery, which might imply that there could be some risk aversion in the coming days,” said Rohit Arora, emerging market Asia interest rate strategist at Barclays to FinanceAsia. “That would be overall negative for emerging market assets.”

Investors were piling into the Asian region’s debt instruments as they grew more confident that the US Federal Reserve (Fed) would only wind down its massive stimulus programme gradually in coming months. That idea was bolstered on September 18 when the central bank said it would not immediately begin cutting back on its bond-buying programme.

The continued stimulus is expected to direct more capital into emerging market assets as investors seek higher yields for their investments, but the increasing risks of a budget standoff between the US Republicans and Democrats leaves no end to a government shutdown that began on October 1.

However, bankers caution that the markets should not overreact or misinterpret the definition of “default”.

“There is the ability for the US Treasury to issue debt but to only issue debt that covers bonds that are redeeming and not necessarily new obligations,” said André de Silva, head of Asia Pacific rates research at HSBC. “Come October 17, that would be the time they can’t issue new debt, but it’s not necessarily as dark as it seems. The US government can still roll over the debt, maintaining market conditions.”

“But this does create some level of disruption and we did have scenarios before where you would get less auctions, less transparency and less liquidity in major bond markets in the world.”

On October 17, the US government will run out of cash to pay its bills unless the debt ceiling is raised.

But even if the debt ceiling is not increased, the US government will continue to pay interest and principal on its debt, leaving its creditworthiness intact, according to Moody’s in a report on October 7.

“The debt limit restricts government expenditures to the amount of its incoming revenues; it does not prohibit the government from servicing its debt,” wrote Steven Hess, senior vice president at Moody’s. “There is no direct connection between the debt limit (actually the exhaustion of the Treasury’s extraordinary measures to raise funds) and a default.”

Selective investments

Despite ongoing concerns of a potential US shutdown, investors are advised by bankers to remain selective when it comes to investing in Asian credit. This could potentially lead to a rebound in Asian bond sales this quarter, especially given that three companies sold debt last Wednesday, the busiest day of the week.

One of the reasons that spurred issuer interest is the fact that 10-year US Treasury yields have dropped significantly, reaching a two-month low of 2.58% on October 3. This happened after Jacob J. Lew, treasury secretary, said the government would not be able to pay its bills in 14 days unless congress raised the $16.7 trillion borrowing ceiling.

Swire Pacific, the biggest shareholder of Cathay Pacific Airways, led the three offerings on Wednesday, printing a sizable $700 million 10-year bond. The trade reopened Hong Kong’s corporate sector in the 10-year space that has been quiet since April, note sources.

Bankers highlight that markets such as Hong Kong and South Korea can benefit from investor inflows because of their stronger balance sheet and to an extent, Malaysia due to its more proactive structural reforms. On the other hand, countries such as Indonesia could continue to see lacklustre demand given  current account deficit problems.

“Differentiation is a key in this environment,” said Barclays’ Arora. “Even though the scenario favours lower yields and a potential delay in Fed tapering, remaining structural challenges among EM economies suggests being selective: either picking bonds in countries with stronger balance sheet or exploiting cyclical factors [such as Malaysia].” 

Regardless of the lingering US debt ceiling concerns, the primary markets in Asia remain resilient with a few mandated deals in the pipeline.

Kookmin Bank, Korea’s largest bank by both asset value and market capitalisation, is planning to sell a three-year dollar benchmark floating-rate bond today at an initial price guidance of three-month US dollar Libor plus 140bp, according to a source close to the deal. Bank of America Merrill Lynch, Barclays, BNP Paribas and Mizuho Securities are joint bookrunners of the deal.

Greenland Hong Kong, a mainland China developer previously known as SPG Land, is also mulling a dollar-denominated bond. Terms have yet to be determined through bookbuilding by Bank of China International, Citi, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan and Morgan Stanley, adds sources.

Additionally, Hong Kong-based China Taiping New Horizon, a wholly owned subsidiary of China Taiping Insurance Group, has hired Agricultural Bank of China, Bank of China (Hong Kong), China Commercial Bank (CCB) International, CICC (HK), Credit Suisse, JPMorgan and Taiping Securities to arrange a series of fixed-income investor meetings. A Reg S dollar-denominated bond offering may follow subject to market conditions.

Year-to-date volume have reached $120.5 billion with 237 deals for Asia ex-Japan G3 DCM, which is not far from 2012’s full-year volume of $139.6 billion with 297 transactions, according to data from Dealogic.

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