Dig Deep—Then Dig Some More—to Uncover Risks in EM Corporate Debt
Emerging-market (EM) corporate debt returned big numbers for investors in recent years, as the sector rode a general wave of optimism about the future. But those days are gone. In 2013, successful investors have had to take a more painstaking path.
This year, investors have succeeded by making careful decisions on securities only after scrutinizing balance sheets and management teams, and identifying pockets of opportunity—while avoiding defaults.
Latin America showcases the point. Default rates there have been very high (display), but investors who avoided the region altogether missed out on some great opportunities. The problems weren’t systemic—they were idiosyncratic.
OGX: Smoke and Bravado Obscured Facts
The most recent Latin American default was Brazilian energy company OGX Petroleo and Gas, which filed for bankruptcy protection in October after negotiations with bondholders failed. OGX was taken public in 2008 by would-be tycoon Eike Batista, and now has the unfortunate distinction of being the largest EM corporate external debt default in history.
OGX made endless promises and projections, but produced virtually no oil. Why was accurate analysis so difficult?
Here’s how: because fundamental analysis of EM corporates requires intense research into country politics/regulations and credit dynamics. In this case, with an oil and gas company, much of the data necessary for making decisions is literally underground. What became clear early in the process was that there was tremendous uncertainty over both the size of OGX’s oil and gas reserves and its ability to produce oil.
Within months of raising capital through bond issuance, OGX stated that it would miss its production targets by 75%. And there was significant turnover in board members and management. For bond investors, the downside risk was large, while the upside was small compared with stocks. Despite the hype associated with the Batista companies and the pre-salt reserves (reserves located below a layer of salt on continental shelves), the compensation just didn’t seem to be there.
Mexican Homebuilders Fail to Adapt to Changing Regulations
Here’s another example of EM risks that took some investors by surprise. During 2012 and 2013, several Mexican housing developers were caught on the wrong side of a policy transition. The companies had access to equity and bond markets, but had run through funds aggressively by buying cheap land and investing in developments far from urban centers.
The Mexican government, which had previously supported homebuilding for low-income families, saw potential problems in the often poorly planned and remote communities, and it began to limit subsidized mortgages for these types of developments. While regulatory specifics were difficult to figure out, rising leverage on homebuilders’ balance sheets and falling free cash flow were clear signs of distress.
In 2012, the bonds posted strong returns. However, the stock prices dropped, which created questions and hinted at distress. Investors who focused on only the credit side of the equation might have missed the alarm, because bond prices didn’t react. A combination of debt and equity research was needed to see the true story.
The question for equity investors was: Now that the stock has sold off, is this an even larger opportunity—or a disaster in the making? For bond investors, the question was: We own this, and it did well, so what’s the downside?
Staying on top of ever-evolving political regimes and policy regulations is always paramount to success. Even with a publicly listed company, on-the-ground research is often the only way to uncover problems. Investors had to meet and speak firsthand with homebuilders, visit developments, meet with local banks and regulatory agencies, and ask questions of industry participants to ascertain that prospects were poor.
Ultimately, the change in government policy was devastating. The three largest listed companies in the industry have now defaulted on their debt. A fourth, which has a more conservative strategy and management, has prospered.
In our view, successfully investing in EM corporate debt requires evaluating a range of risks, including the idiosyncrasies of shareholders, managements and local politics, and changes in regulations. Investors can’t rely on riding a wave of beta—they’ll have to dig deep with comprehensive fundamental analysis and examine risks from multiple perspectives.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Shamaila Khan is a Portfolio Manager for Emerging-Market Corporate Bonds at AllianceBernstein.