Higher Yields To Compound Regional Downturn

BMI View: The surge in bond yields across the region is coming at a time of economic weakness, which is a dangerous combination. From Indonesia to India to China, corporates are feeling the pinch of higher borrowing costs amid already weak macroeconomic trends. The threat of a vicious cycle taking hold, where rising corporate bond yields weaken economic growth, leading to further increases in corporate bond yields, is looking like a distinct possibility.

In December last year, with the region looking poised for an acceleration in economic activity, we cautioned that a number of unforeseen risks could impede economic growth. Among the risks, we highlighted the potential for a reversal in sovereign and corporate bond yields across the region following a record plunge in borrowing costs.

"…credit default swap markets across the region are trading near record lows as the suppression of global volatility and low interest rates have encouraged a flood of capital into Asian bond markets… any hiccup in global financial markets would leave Asian markets extremely at risk in terms of rising borrowing costs"

4% Corporate Yields Not Likely To Return
Asia - Corporate Bond Index Yield, %

Higher Yields To Compound Regional Downturn

BMI View: The surge in bond yields across the region is coming at a time of economic weakness, which is a dangerous combination. From Indonesia to India to China, corporates are feeling the pinch of higher borrowing costs amid already weak macroeconomic trends. The threat of a vicious cycle taking hold, where rising corporate bond yields weaken economic growth, leading to further increases in corporate bond yields, is looking like a distinct possibility.

In December last year, with the region looking poised for an acceleration in economic activity, we cautioned that a number of unforeseen risks could impede economic growth. Among the risks, we highlighted the potential for a reversal in sovereign and corporate bond yields across the region following a record plunge in borrowing costs.

"…credit default swap markets across the region are trading near record lows as the suppression of global volatility and low interest rates have encouraged a flood of capital into Asian bond markets… any hiccup in global financial markets would leave Asian markets extremely at risk in terms of rising borrowing costs"

With fears over a winding down of Quantitative Easing by the US Federal Reserve recently coming to the fore, bond yields across the region have risen sharply. According to data compiled by Bloomberg, 98% of Asia's US dollar-denominated bonds issued in Q213 are now underwater.

4% Corporate Yields Not Likely To Return
Asia - Corporate Bond Index Yield, %

While rising sovereign yields are often a signal of an uptick in economic growth, this time around a different dynamic appears to be in play. In fact, in most cases we are seeing economic growth slow, and in some cases slow sharply. The chart of regional Purchasing Managers' Indices shows how the increase in bond yields is deeply at odds with the trend of economic activity.

Region-Wide Downturn Continues
Asia - Purchasing Managers' Indices

Tightening The Screws

In the face of this slowdown, a reset from extremely compressed sovereign yields is currently underway, impacting corporate bond markets across the region. The threat of a vicious cycle taking hold, where rising corporate bond yields weaken economic growth, leading to further increases in corporate bond yields, is looking like a distinct possibility.

One way or another we are seeing a shift across the region towards higher borrowing costs, which is likely to compound the deterioration in economic growth. Indonesia, which we highlighted as being particularly vulnerable to hot money outflows, was forced to hike interest rates in order to stem inflation expectations after yields rose by more than 3 percentage points since the start of the year. This is in the face of a clear slowdown in the economy. Despite being relatively optimistic in terms of South East Asian growth prospects, we highlighted at the end of last year that hot-money outflows could have the impact of dampening credit growth and weakening currencies, which could be particularly painful for corporates that have engaged in external borrowing. Indonesia continues to be the country most at risk from this dynamic.

Yield Surge To Hit Corporate Sector
Indonesia - 10-Year Bond Local Government Bond Yield, %

In a similar vein, on June 15, the State Bank of India acted to shore up the country's external accounts with liquidity draining measures and hikes in its Marginal Standing Facility and Bank Rate, amid fears over the intense weakness in the Indian rupee. This comes at a time when the Indian economy is still struggling to find its feet, and these marginal tightening moves will certainly not make a recovery any easier.

China is particularly at risk. The economy is heading for a downturn at a time when external forces are adding insult to injury. Chinese real-estate corporate bond prices have fallen dramatically in recent months due to a combination of investors fleeing emerging-market debt and worries over China's own real-estate market. The cash squeeze that happened in mid-June is likely to compound problems for Chinese corporates. Although facing declining profits and cashflows, a hike in bank borrowing costs is likely to intensify the economic downturn. Our autos sector team has already seen the impact on the domestic autos industry, and we expect incoming macroeconomic data to show that other industries are also feeling the pinch.

While Japanese bond markets have found some stability in recent months, the sovereign bond market is still on a knife edge in our view. We believe that sovereign yields bottomed out in early April, and rising inflation expectations as a result of the ramp up in bond purchasing will see yields rise much further over the coming quarters. Any surge in yields would undermine corporate yields, where we would expect to see an outsized spike in borrowing costs given the added default risk.

As Chinese demand continues to falter in the aftermath of its unprecedented lending boom, this will have a negative impact on economic activity across the region, and we expect to see the spread between corporates and sovereign yields head higher over H213. Should this happen while global rate pressures remain to the upside, we could see a rise in default rates and a region-wide recession.

Investment Banking Earnings Set To Take A Hit

While 2012 and the beginning of 2013 saw record amounts of emerging market bond issuance, the tide has turned suddenly, with debt sales having come to a near standstill over the past two months. According to Dealogic data (as cited by the Wall Street Journal), after China Huaneng Group sold a US$400mn bond on June 4 there were no bond deals in the entire region for the remainder of the months.

Fees from investment banking in the region fell to US$$3.6bn in H113 from US$4.0bn in H212, according to Dealogic, marking the lowest level since the first half of 2009. Debt issuance started to overtake income from mergers and acquisitions and share sales as the biggest source of investment-banking fees in Asia in H212, and in H113, income from debt deals accounted for 43.4% of the investment-banking fee pool for Asia ex-Japan, up from 40.4% in H212.

A combination of bond sales from Chinese and Indonesian state-owned oil giants and a flurry of issuance by low-rated Chinese property developers were the main driving forces of bond-related revenues in recent months. However, the Asian high-yield bond boom came to a grinding halt in June, and we believe that it will be a number of years until we begin to see bond activity climb back to its recent levels.

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