Investors are stampeding to lend to the world’s riskiest companies and countries. Quartz spotted this trend back in October, and it has just got stronger since. Usually a conservative bunch, bond fund managers now cannot get enough of debt issued by Chinese property developers or risky governments such as Vietnam.
Blame the Fed and other central banks. Investment yields on Treasury bonds and debt sold by blue chip companies have collapsed. As the Wall Street Journal comments, investors are “chasing yield in far-flung places”. Western governments, pumping money into their economies, will likely keep interest rates at rock bottom for years, while risky companies from developing markets pay high interest to borrow cash.
But the rewards can blind one to the perils. Country Garden and Kaisa Group, two Chinese residential-property developers, drew a massive $28 billion of orders for a combined $1.25 billion of high yield bonds—the banker’s polite term for junk debt—sold in the last few days, according to credit publication IFR. Country Garden’s bond pays 7.5% interest and Kaisa’s pays 10.25%.
They are rated junk for good reason. The oversupply in China’s bubbly housing market is well documented. Standard & Poor’s just downgraded Country Garden because of “challenging conditions” in Chinese real estate, and says archly that Kaisa has “limited consistency in financial management.”
Similarly, though Vietnam’s economy is slowing and it could be facing a banking crisis, demand for government bonds is rising rapidly. The country’s debt is rated below investment grade by Moody’s and Standard & Poor’s. Moody’s downgraded Vietnam last September because of the likelihood the Hanoi government will have to bail out failing banks.
It is not just junk bonds investors are rushing into. Anything moderately exotic will do. This chart from HSBC shows how foreign ownership of Mexican, Peruvian and Indonesian government debt has hit record highs.
The pace is accelerating. In the first eight months of this year, 25 companies from the BRIC countries sold junk bonds, raising a combined $10.3 billion, according to Dealogic. In the last four months, there have been 30 BRIC junk deals worth $13 billion.
Emerging-market companies and governments will welcome the financing. But hidden risks are piling up. The first is that these countries are lax about protecting investors when bond issuers default. In Indonesia, for example, courts are generally unsympathetic to the wishes of foreign creditors. Chinese bankruptcy laws are new and untested, and in China, foreign creditors often find the local courts will not help them grab a failed firm’s assets. In Mexico, legal loopholes related to inter-company loans allow bankrupt companies to be treated by the courts as their own biggest creditors.
The other major risk is to the debt issuers themselves. Fund managers are buying this junk debt mainly because it offers higher interest rates, not because the issuers are fundamentally sound, so their loyalty is fickle. Cash will probably rush out of emerging markets again as soon as the numbers stop making sense.
“The window of opportunity for Latin American [bond] issuers can close quickly,” says Joe Bormann, a managing director at credit ratings agency Fitch Ratings who tracks Latin American corporates. So too for Asian companies: The Asian high-yield debt market shut down completely for 106 days between July and December 2011, according to a Quartz analysis of Thomson Reuters data.
That means emerging-market firms could face cash crunches. A fast-growing company typically gobbles up capital to fund its expansion and repays its debts with new borrowings, since sales aren’t yet big enough to cover them. Country Garden, for example, will be using some proceeds of its recent $750 million bond sale to pay off old bonds that are about to come due (pdf p.1). This business model is common across developing countries.
This “refinancing risk” is something that anyone holding emerging-market junk bonds should examine closely. Like those countries’ arak, baijiu, tequila or other local liquors, their junk debt feels good and strong at first, but the resulting hangover can be awful.