Shamillia Sivathambu, Investment Writer
Argo Capital Management
Emerging market sovereign debt spreads have rallied in the past few months, while emerging market equities and currencies have all bounced back from their significant lows at the tail end of last year. Inflows seem to be making a return to those markets that suffered repatriation of capital following the collapse of Lehman Brothers last September. While this recovery of risk appetite is encouraging and there seems to be a gradual merging of fundamentals and technicals again among some emerging market assets, we are still not entirely out of the woods.
There is some feeling that emerging market equities could be heading for a pullback, having advanced so much so quickly. The MSCI Emerging Markets Index has gained close to 35% so far this year and there is some concern that the rally has left valuations less attractive. And while loans and bonds too have rallied, allowing some new issues to take place; in other quarters there is a feeling markets have run ahead of fundamental developments and spreads have come in too much. Furthermore, opportunities remain, especially in Central and Eastern Europe where some companies have over-extended themselves.
Rising loan and bond prices have begun to facilitate distressed debt trading activity as investors take advantage of improving prices in the credit markets to manage their exposure. Up until now, bids have remained too low to stimulate any meaningful activity in the secondary market for distressed assets. But with investors once again seeking higher yielding assets and defaults beginning to trickle in, the space is beginning to show encouraging signs of life.
There have already been some significant defaults so far this year and distressed debt specialists are expecting to see an increase in trading later in the year. BTA Bank’s partial default this year was the first sizeable default for Kazakhstan. Two other Kazakh banks missed their principal payments pushing them into default. Kazakh bank Alliance, BTA Bank and a smaller lender Astana Finance have some US$20 billion of foreign debt that needs to be restructured.
Separately, Siberian Services Co, a Russian oil-drilling company, defaulted on US$100 million of bonds, making it the first Russian borrower to fail to repay its foreign debt this year. In addition, Finance Leasing Co, the leasing subsidiary of OAO United Aircraft, is the first Russian state-owned company to default on foreign debt since 1998.
However, with banks downsizing their research teams, analysts are no longer covering as many names as before. The little research that is finding its way to the buy-side is very conservative and primarily dedicated to the investment grade space, making it difficult to spot the opportunities and avoid the pitfalls. Against such a backdrop, creditors with expert asset valuation skills are in a strong position to tap the thinly covered space through either active or passive investing strategies.
When it comes to valuing assets in emerging markets, traditional valuation techniques are often insufficient. Broadly speaking, there are pre-requisites to achieving expert valuation in emerging market bonds:
knowledge of and expertise in bankruptcy law, negotiations and workouts;
valuation of a broad range of securities;
access to additional capital and a strong network of contacts are some of the factors to consider.
A reputation for winning over management and experience in trading through crisis periods are also imperative to the valuation process.
Additionally, valuation of the entry price, the borrower’s willingness to repay its debt, its track record in company management, financial metrics such as cash flow, debt ratios and health of the balance sheet should also feature strongly at the outset. The degree of cooperation and support exhibited by shareholders and the size of the company’s market share are equally crucial to the credit selection process.
In the current market environment however, the valuation process should go a step further and incorporate a greater degree of granularity, namely when analysing a company’s corporate documentation and corporate structure. Establishing where the primary assets are held and the ownership structure will help minimise unwanted surprises further down the line. Equally important is thorough competitor and sector analysis, a clear understanding of the owner’s agenda, liquidity, exit strategy and the ability to implement it.
Enhanced comprehension of the local legal framework and the ability to exert rights are also crucial, especially in developing markets, which often require innovative responses to unprecedented problems. When Essar Steel, a large Indian company defaulted on its debt, Argo Capital Management (ACM) was not prepared to litigate in the local courts as it felt its rights might be difficult to enforce. Instead, ACM sued for repayment through the English courts – and won – in a landmark case, which helped establish hedge funds as formidable players in the loan market. In emerging markets, debt restructuring can also be without precedent in certain cases, which is why exposure to local bankruptcy proceedings and restructurings can help ensure a favourable outcome for creditors.
Accurate valuations also assist with timing entry and exit strategies and deciding if it is beneficial to invest in stressed situations in lieu of distressed opportunities. This should entail investing in companies that have sound underlying assets and cash flow potential but face reversible liquidity issues. The ability to make such calls is especially relevant in the current market, where emerging market assets are beginning to look oversold and determining its ‘true’ value will require deeper fundamental analysis. It also gives investors a dual source of returns, making their capital work more efficiently for them.
So before you decide if emerging market assets are fairly valued at current prices or if they do indeed look oversold, it might be worth asking how such valuations were achieved in the first place. You might find that the means do not always justify the end.