CHALLENGES IN THE CREDIT ANALYSIS OF EMERGING MARKET CORPORATE BONDS

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CHALLENGES IN THE CREDIT ANALYSIS OF EMERGING
MARKET CORPORATE BONDS
ICEF-HSE October, 2
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SUMMARY

• Use high-yield style credit skills, but one
  should be prepared for the unexpected
• Do not assume that E.M. utility is the same as
  U.S. one, but understand the differences as well
• If you can not get good information form
  management or cannot get a good grip on cash
  flow, stay away from the bond altogether
• If management is modern and informative and helps
  you get comfortable with the risk, you can
  increase the probability of higher risk-adjusted
  returns

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INVESTMENT APPROACHES FOR E.M.
Investing in emerging market corporate bonds can
be most profitably done using techniques
practiced for high-yield bonds and taking into
account unique factors of the emerging markets

• Traditional approaches to investing in emerging
  market corporate bonds
• Top-down treats investing in corporates as
  sovereign-plus
• Bottom-up treats corporates of emerging markets
  as U.S. credits-plus
• Investment decision should be done basing on the
  financial ratios and credit statics, as well as
  on the following factors
• Volatility of emerging markets (ratios should be
  stronger)
• Inflation accounting distorts results (increasing
  inflation)
• Accounting standards are less rigid
• Underdeveloped and unreliable legal system
• Recessions tend to be more severe
• High degree of governmental intervention (support
  local companies)
• Investing into emerging markets and taking into
  account the above risks investors are adequately
  compensated by high yields

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E.M. CREDITS V.S. U.S. CREDITS WITH SAME RATING

• The solid investment-grade ratios were the reason
  for survival of Latin companies even during
  drastic downturns (Mexico and Argentina 1995,
  Brazil and Argentina 1999)
• Because of there location in volatile environment
  these companies have BB grade rather than
  investment grade, even though investment grade
  ratios are solid in terms of U.S. standards
• Despite their higher ratings, Asian companies
  encountered more problems when there economies
  collapsed due to
• Higher leverage, higher levels of short term
  debt, less transparent accounting
• Trading risk is another significant variable
  (volatility and liquidity)
• Latin bonds are inherently more volatile and less
  liquid than U.S. high-yield bonds
• Investors should be aware that their assets are
  highly sensitive to outside shocks
• The latest crisis came from U.S.
• Investors should ensure that they are compensated
  for baring extra risks
• Compare yields on a basket of similarly rated
  U.S. corporates
• Reduce exposure if the spreads are within 100 or
  200 basis points

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TIERING THE CREDIT
Credit fundamentals are usually the determining
factor in whether a bond is repaid

• Trading in the emerging markets is often based on
  a companys local reputation, as opposed to
  credit fundamentals. But blue chip reputation and
  credit strength may or may not be related
• It is recommended that investors rank credits in
  three categories based on standard credit risk
  measures
• Cash flow ratios
• Risk and volatility of industry
• Size of a company
• Competence of management
• Still some of the local blue-chips will be traded
  better even though they have lower
  characteristics than those of top-tier according
  to the U.S. methodologies
• Not a strong management was a reason for the blue
  chips to become what they are now
• The recent trend is that the divergence between
  perception and credit reality will continue to
  close

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JUDGING COMPANIES BY INFORMATION PROVIDED
Lack of information flow and poor credit risk and
weak management often go hand in hand

• Many emerging market companies especially the
  better managed ones have learned to treat
  investors as a key constituency rather than a
  nuisance to be tolerated
• Several rules of thumb
• Avoid private companies (those that do not report
  to a stock exchange) unless their bonds are
  registered with the SEC and they have a New
  York-based investor relations firm (hard to hold
  of fin. Results when it turns to worse, bonds
  virtually always lag, secondary trading is
  illiquid)
• Demand a premium for issuers that do not have a
  New York-based investor relations agency
• Demand a premium for companies that do not file
  U.S. GAAP, or at least an annual U.S. GAAP
  reconciliation
• Investors should always check the reconciliation,
  just to understand the differences in what is
  reported quarterly and what is filed at year-end
  with SEC
• In Asia, disclosure and transparency have
  improved since their crisis
• Still accounting standards remain significantly
  below par and much worse than Latin

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DEBT STRUCTURE MATTERS COVENANTS

• The key credit variables revolve around cash-flow
  ratios
• Most analysts agree that some form of ratios that
  measure cash flow earnings relative to fixed cash
  payments (EBITDA/Interest on debt/EBITDA) provide
  the best measurement of credit risk
• If one wants to create a covenant that best
  protects creditors, t should be a cash-flow-based
  ratio
• Calculations on pro-forma basis should be
  required to ensure that the ratio is as current
  as possible
• Investors should require covenants that measure
  all fixed calls on cash flow, including
  off-balance-sheet debt and mandatory preferred
• In a region where legal recourse is difficult, it
  is important that all covenants should be
  self-enforcing
• Control over management can be maintained through
  the comprehensive incurrence tests

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DEBT STRUCTURE MATTERS CRITICAL ROLE OF MATURITY
PROFILE
The lesson to be learned from recurring financial
crises in E.M. is that short-term debt is bad.
Many E.M. firms have improved there debt profile
and retired shorter-term debt

• The credits issuers that still use high-risk
  short-term debt (commercial papers) should
  probably be avoided
• A willingness to tolerate a risky level of
  short-term debt usually is a sign of poor
  management
• A short-term debt usually automatically rolls
  over, becoming effectively evergreen
• In unstable financial environment bad ratios are
  not as dangerous as immediate refinancing
  requirements are. In fact default is mostly
  caused by pay debt obligations
• If there are no obligations coming due for a long
  time, the risk of default is reduced
  significantly
• The debt structure (upcoming debt maturities) is
  the most important credit variable in emerging
  market, even more so than cash flow ratios
• Debt arbitrage (borrowing USD to avoid steep
  local interests) is one of the related issues
• This strategy provide high returns in good times
  (reinvesting in local currencies with high
  rates), but when the crisis hits
• This is also sends a negative sign about
  management
• Management likes to gamble
• Does not see many profitable investment
  opportunities in its core business

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INFLATION ACCOUNTING
Inflation accounting makes it more difficult to
truly understand what is going on in a company

• Another rule of thumb
• Never believe any numbers where inflation is
  above 50, unless they have been translated into
  hard currency at the time of the transaction
• Even with around 20 inflation, the cash flow
  statement is distorted so as to make it almost
  meaningless
• Investors should demand a significant premium if
  the companies do not separately disclose the
  inflation and devaluation component of their
  interest expense, as it is a key variable in
  estimating companys credit risk
• Key earnings variable for many credits, is the
  strength of the local currency. As inflation
  comes under control, the many companies that were
  able to compete based on their weak currency will
  have to start competing based on their core
  competencies.
• Avoid companies that complain about the strength
  of the currency and loudly call for devaluation
  rather than proactively investing or
  restructuring so that they can compete regardless
  of the strength of their currency
• With inflation coming down cost controls become
  more important, and operating margins no longer
  benefit from the inventory effect