LONDON The $1 trillion (640 billion pound) market in emerging corporate bonds could be headed for a surge in defaults if company earnings in swiftly depreciating roubles or pesos fail to keep pace with dollar-based debt repayments.
As the U.S. Federal Reserve considers when to turn off its printing presses, emerging currencies have crashed to multi-year lows against the dollar. That rout is a big risk for corporate debt, which has gone from being a sideshow of the sovereign bond market to an asset class that surpasses U.S. junk debt in size.
As past decades show, a surging dollar can make trouble for emerging markets, rapidly pushing up debt service costs.
And implications go far beyond the companies themselves. Corporate defaults can lead to bankruptcy, share price falls, job losses and even sovereign stress, if governments are forced to step in as was the case in Asia during the 1997 crisis.
Corporate vulnerability was one of the motivations behind Russia's costly $200 billion defence of the rouble in 2008.
In Mexico, several real estate firms are currently struggling. As investors flee such firms, a chain reaction raises borrowing costs across the sector, making it harder for others to refinance debt.
"Corporates are like popcorn - once one starts to pop the others are going to join," said Sergio Trigo Paz, head of emerging debt at BlackRock. "This is happening, as we speak, with Mexican homebuilders."
"Should the dollar get stronger, revenues in local currency will not match the coupon payments," Trigo Paz added.
The bond boom was of course a response to paralysis in bank loan markets, once a common borrowing avenue for emerging companies. But the numbers are still astounding.
Emerging corporate bond sales have doubled since 2005 to a record $200 billion last year but that figure was already surpassed this year by end-May. Companies account for 80 percent of all hard currency debt sold in 2013, ING Bank data shows.
Many such companies will have hedged dollar exposure. But given that expectations have been for emerging currencies to strengthen, such protection is by no means universal, says Colm McDonagh, head of emerging debt at Insight Investments.
"If your revenues are in, say peso, and you have debt in dollars, do you hedge the whole time? The cost could be very high," says McDonagh who has gone overweight cash in his funds.
He also notes that much recent borrowing has come from junk-rated credits. ING data shows almost 40 percent of issuance this year is speculative and nearly a quarter had no rating at all.
Corporate yields have blown out almost a half percentage point since early May to 374 basis points over U.S. Treasuries. Demand to hedge risk via credit default swaps has also risen: spreads on corporate CDS indices run by Markit in emerging Europe and Latin America have risen 80-100 bps since mid-May.
WORRIES BUT NOT 1997
For emerging market watchers, the scenario is familiar. In 1997, the crash in currencies such as the Korean won and Thai baht plunged over-leveraged companies into default, their spiralling debt repayments almost causing sovereign insolvency.
Back then, around a third of outstanding emerging corporate debt went into default. Even as recently as 2008, defaults rose to 10 percent, with delinquents as diverse as Brazilian meat packer Independencia Alimentos to Kazakh bank BTA.
But only the gloomiest foresee a reprise of 1997 in 2013.
First, junk-rated companies owe $33.6 billion in principal and interest this year, or a third of the total corporate payments due, ING says, describing the amounts as "manageable".
Second, the biggest debt increases have come from energy firms, and banks, often state-run, research by JPMorgan shows. The former have a natural hedge via dollar-based revenues and banks are usually regulated to limit foreign exposures.
Russian banks Sberbank and VTB both told Reuters they hedge exposure or utilise bond proceeds for foreign currency loans.
"The situation today compared with 2008 is different," central bank governor Sergei Ignatyev said last week. "Back then, net foreign assets of the banking system were minus $100 billion. But now, as of June 1, it is plus $72 billion - see the difference?"
As in prior crises, some sectors, countries and companies are more vulnerable. Analysts say the most pain could be felt by utilities, retailers, consumer goods and real estate firms whose cash flows tend to be in domestic currencies.
In Turkey, where corporate borrowing has rocketed, gross hard currency liabilities in the coming year are estimated around $155 billion, mostly corporate. While Turkish banks, like most peers, use cross currency swaps to hedge part of their risk, short-term liabilities well exceed central bank reserves.
Other possible hot spots, JPMorgan says, are Chinese property firms - which account for most of the $68 billion Asian real estate debt outstanding - and Indonesia where the currency could fall past levels at which hedges are capped.
Ukraine or Kazakhstan with little access to hedging are also at risk if firms lack natural hedges. Kazakh BTA and Ukraine's Naftogaz were among defaulters after the 2008 crisis.
JPMorgan compares Ukrainian metals conglomerate Ferrexpo, which exports 100 percent of its output, with poultry farm MHP which exports less than a tenth. Yields on the latter's dollar bond are up over 100 bps since end-April, more than double the move in Ferrexpo.
(Additional reporting by Carolyn Cohn in London; Oksana Kobzeva and Ekaterina Golubkova in Moscow; Graphic by Natsuko Waki; Editing by Ruth Pitchford)