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Capital Markets Weekly: Emerging markets increasingly rely on official lenders
Debt issuance volumes have revived sharply, with US companies raising a record volume during March and a sharp revival in ESG activity during the last few days, but pressures on emerging market borrowers continue to grow, with South Africa having lost its last non-junk rating, increasing EM reliance on official funding sources such as the International Monetary Fund.
Despite the difficult and volatile environment, ESG issuance has revived substantially:
On 26 March the regional government of the Basque Country sold its second sustainable debt issue, a EUR500 million offering priced at 0.85%, 25 basis points over comparable Spanish government debt. The deal was seven times subscribed, with demand split evenly between domestic and international subscribers. EUR355 million will be used in the fight against COVID-19, "our absolute priority" according to the region's statement: EUR130 million will be applied for healthcare and EUR255 million in related social programs.
In addition, Pfizer issued USD1.25 billion of sustainable debt while Consolidated Edison of New York issued a two-part Green bond:
Pfizer sold its first such issue as a 10-year deal priced at 2.625%. Proceeds will support environmental sustainability projects and improve access of vulnerable groups to its drugs and medicines. Pfizer's statement describes the deal as the "first in the industry sustainable bond". Use of proceeds will include improving energy efficiency, water conservation, reduced waste and improved recycling. Among other goals it will also focus on key development projects including COVID-19 and antimicrobial resistance, while helping to improve health systems in lower-income countries.
Consolidated Edison placed USD1 billion of 30-year bonds at 3.988%, a 255-basis point margin over US Treasuries, along with USD600 million of 10-year debt at 3.377%, at the same spread over Treasury bonds. The firm is sensitive to ESG issues: in addition to focusing on wind and hydro power, it published a climate resilience study in December 2019 looking at historical and projected climate impacts to its service area, including "extreme heat, coastal storm surge, inland flooding and more violent storms". The study showed the company's energy systems to be subject to increasing flooding risk, with its electrical system also challenged by extreme heat: the New York City/Westchester region's temperature is expected to move from exceeding 103 degrees Fahrenheit on two days a year at present to 26 days by 2050.
The African Development Bank (AfDB) raised a USD3 billion "Fight Covid-19 Social" bond, designed to "alleviate the economic and social impact" of the pandemic. The three-year bond, priced at 0.75%, gained demand of over USD4.6 billion. According to AfDB's statement the deal is the largest social bond arranged to date, as well as its own largest offering. 53% of the allocations went to central banks and other official institutions, with bank treasuries and asset managers taking 27% and 20% respectively.
Lastly, InterAmerican Development Bank sold USD2 billion of five-year debt. On 26 March it announced a four-pronged program to help its members, focusing on
- COVID-19 mitigation by strengthening healthcare systems and buying medical supplies
- Provision of "safety nets" for vulnerable groups along with transfers to workers in the informal sector and support to companies in badly damaged sectors such as tourism.
- Helping SMEs, described as providing 70% of the region's employment.
- Funding fiscal measures in response to COVID-19 and to encourage recovery.
According to Dealogic data cited by the Financial Times, despite the much higher cost of borrowing, high-grade corporate issuance during March has reached USD244 billion including a record USD150 billion for US firms, as companies rushed to lock in additional liquidity. Supply from US firms reached USDS73 billion last week, also a record. Monthly supply rises to USD408 billion after including bank debt sales.
One adverse development last week was the downgrading of Ford by two major agencies to junk ratings, moving USD36 billion of its debt into the sub-investment grade category. Media reports claimed that the company is drawing on its USD15.4 billion bank credit lines.
While spreads remain much higher, on 26 March Air Liquide, which manufacturers industrial gases, priced EUR500 million tranches of five and 10-year debt at 120 and 140 basis points respectively, which represented a zero or negative premium to its outstanding curve, unlike the significant new issue premiums generally required recently.
On 30 March, European supply has restarted vigorously, with multi-tranche offerings by Volkswagen and AB Inbev, with three, five and eight-year supply from the former and long seven year, 12 and 20-year bonds from the latter. By mid-morning these had attracted EUR5 billion and EUR16 billion respectively, with a EUR1 billion deal for Nordic Investment Bank also nearly three times subscribed.
According to Investment Company Institute data cited by the Financial Times, in the week to 25 March, mutual and exchange traded money market funds attracted a record USD286 billion of new inflows. The report claims that the main beneficiary group was funds that invest in government debt, while those holding short-term corporate debt such as commercial paper faced outflows of USD53 billion. According to the US Department of the Treasury, one, three and six-month bills all yielded zero on 25 March, having all started March at yields of over 1%.
The same source also cited EPFR Global data showing outflows of USD17 billion from Emerging Market debt funds in the week to 25 March, following USD18.8 billion of outflows, a record, in the preceding week. The report noted that USD47.7 billion have been withdrawn in four weeks from such funds, equating to 10.2% of assets under management. The report provides interesting reference points to evaluate these outflows:
- According to Bank of America, net inflows to such funds totaled USD140 billion during the prior four years.
- While very severe, redemption percentages are below those recorded during the Fed "taper tantrum" and the 2008/9 financial crisis, when outflows reached 16% and 34.5% of assets under management respectively.
- Unsurprisingly the withdrawals have led to sharp declines in EM bond prices: JP Morgan indices for hard-currency and local currency EM debt have fallen 10.9% and 14% during 2020.
South Africa's loss of its Moody's investment grade rating for its domestic debt (international bonds were already all junk rated) threatens new outflows from rand-denominated portfolio holdings, although investors have been aware of the downgrade risk for an extended period.
Outlook and implications
Recent developments indicate three main developments:
High-grade issuers are stepping up their issuance of new debt to boost liquidity and tide them through COVID-19 related production disruptions. While some details of the Federal Reserve's support for the corporate debt market still await clarification, the large volumes of completed issuance indicate the success of quantitative easing measures in underpinning the high-grade segment of the debt market. While reported fund flows continue show a rush towards safe-haven cash instruments, it is clear that investors have been successfully attracted by the far-higher bond returns available, with some indicators that new issue premia have at least stabilized, and in Air Liquide's case, declined back towards zero.
Outflows from Emerging Market debt are sizeable but unsurprising, given the dual shocks from COVID-19 and weak energy and natural resource prices. As previously highlighted, there are clear risks of growing stress in this segment.
In turn, this increases the need for official support to Emerging Market countries for them to avoid a squeeze in liquidity and the threat of having to choose between essential healthcare and welfare initiatives or servicing their debt. Fortunately, as reported last week, there are clear signs of encouraging policy responses by official lenders.
On 27 March, IMF Managing Director Kristalina Georgieva reported that over 80 countries have approached the fund for emergency financing. She stated that some 50 of the requests were low income countries, and that requests for help from this group were "coming fast". Additionally, she noted that middle income countries were engaging "very actively" with the Fund, and that "we encourage them to do so".
To face these challenges, the IMF specifies four measures that it is taking to increase its support capacity:
- It proposes to double its Emergency Financing capacity from USD50 billion, while simplifying its processes.
- It is reviewing its set of lending instruments to identify potential gaps in addressing COVID-19 requirements, including consideration of expanded use of precautionary credit lines and short-term liquidity facilities.
- Its Board has approved changes to its Catastrophic Containment and Relief Trust to provide debt relief to poorer countries and has asked its members to increase the capacity of this lending segment.
- Finally, the IMF is seeking new arrangements to increase the borrowing capacity of the fund, citing components of the US stimulus package as a positive indicator.
Overall, the proactive stance of official lenders is a strongly positive indicator. Active support from the IMF and World Bank, among others, lowers the risk of debt stress in Emerging Market countries and helps to preserve financial sector stability. The IMF plans to submit a detailed set of proposals to the April G20 meeting, the outcome of which is crucial for Emerging Markets.
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