Asia Credit Commentary July 22, 2014

* THIS IS A PRODUCT OF SALES AND TRADING DESK, NOT RESEARCH. THIS

MATERIAL IS A SOLICITATION TO ENTER INTO A DERIVATIVE TRANSACTION
UNDER CFTC SECTION 1.71(a)(9)(iii). FOR INSTITUTIONAL INVESTORS ONLY.

Desk Analysts
Hello, Goodbye
- The Beatles Nomura International (HK) Ltd

Pradeep Mohinani, CFA

+852-2536-7030
In this issue we focus on:
pradeep.mohinani@nomura.com
• A reflection of where the Asian credit markets have come from…
• … with a benign 2H outlook for spread performance and 2015 fraught
with more risks

It has been a tremendous 18-year experience in sell-side credit research

which has enabled me to learn about the development and drivers of
markets through extensive reading and meeting of some of the smartest
minds, while making loads of friends along the way. However, the time
has come to seek a fresh start with new challenges. And so in this final
note, I hope to reveal some of the greatest lessons I have learned and the
issues that could drive the Asian credit markets. But before proceeding
further, I want to wish Annisa Lee the best of wishes in the years ahead as
she takes the reins of running the team.

The early years of 1996 to today

In 1996, the Asian credit market was only a fraction of today’s size, at
roughly US$30bn in US-denominated bonds outstanding. Credit spreads
were tighter than current levels, although overall yields were higher with
the 10-yr USTs hovering at 6.4% in 1996. There were, on average, 10-15
deals issued each year with every issuer and sector extremely well
covered given the small size of the market and every sell-side team
staffed with at least 3-4 analysts (oddly, just a shade smaller than the
average size of current teams despite the tremendous growth in the
market). As compared to the straight bond market, most of the action took
place in convertibles with a similar bond market size although shorter-
dated maturities, zero-to-low coupons and high premiums reflecting the
go-go times. Taiwan and Hong Kong issuers dominated that market with a
handful of issuers from Korea and the Philippines. Regardless of the size
of the market, those early years were crucial in truly understanding the
importance of credit analysis and anticipating future trends.

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1996 was the last of the boom years before the Asian financial crisis took hold and ravaged Asian
economies and markets. However, the signs of the excess were everywhere and the cracks were starting
to show. Industrial capacity across steel, petrochemicals, real estate and autos sectors were in oversupply,
while new capacity was still being built on cheap short-term foreign capital. Thailand was the first to show
such signs of stress with practically every steel company folding by the end of the year to the early part of
1997. Similarly, property companies that had booked fantastic revenues from small deposits for half-built
properties were running tight on cash, while never-to-be-paid receivables built up. Finance One, Thailand’s
largest non-bank finance company, was set to become the first and largest distressed financial issuer
reflecting a growing NPL problem, and finally, on 1 July 1997 as China celebrated the handover of Hong
Kong, the Thai baht devalued with the country effectively out of FX reserves.
The crisis moved from Thailand, to the Philippines, Korea and Indonesia with greater speed. The first
lesson was that growth and profitability were unjustly projected to grow at exponential rates, and what the
lack of transparency from sovereigns down to corporates did not help. Similarly, the variability in accounting
policies did little to alter the leverage of issuers. For example, accounting policies in Korea were regularly
changed by varying depreciation rates every year to suit the targeted profitability. Adding to the flare of
creativity of accounting policies was the deferment in foreign exchange losses over the life of liabilities
outstanding as opposed to taking the entire hit up front at the end of 1997. The purpose was to preserve
the book equity of companies, otherwise most would have had negative book values.
The defaults by the Chinese international trust and investment corporations (ITICs) were perhaps the
biggest surprise of the crisis. Bonds were backed by letters of support that held little value and did not
necessarily have all the SAFE approvals for repaying overseas debt. Restructurings varied by issuers with
some tougher than others. The question of whether the experience could repeated itself is valid considering
the current wave of SOEs coming to market with high leverage and a ratings uplift due to central or state
support. We would argue otherwise. If there were a wave of defaults, bond markets would soon freeze up
to the rest of the Chinese issuers for which further financing needs are high. In addition, the recent
improvements in select credit profiles are benefiting from either lower input costs or reform measures. With
more reforms just announced for SOEs to improve governance and balance sheets, if there were a wave of
defaults in the next couple of years, we would think the issue would be well flagged and contained.
Fortunately, the Asian crisis, while sharp and painful, was short given the reset button was hit and the
region benefited over the next eight years from the export engines kicking in and China’s entry into the
WTO providing another impetus for growth. More importantly, issuers and governments set about cleaning
up their balance sheets with better planning, transparency and governance. The improvements were
rewarded by rating upgrades. All the efforts to clean up were reflected in Asia’s fast bounce back in 2009
after the GFC, although supported yet again by China’s RMB4tr central government stimulus program,
which provincial governments further boosted by twice that amount invested.
During the economic recovery following the Asian financial crisis, Asian credit markets grew in size and
spreads tightened generating fantastic returns year after year, similar to the experience of 2009 and 2010.
By 2006, the credit markets had reached about US$160bn, still less than a third the size of today’s market.
With the creation of leveraged structured products and easy money, Asia HY’s bond market’s did not
flourish, as many deals were sent to the private hedge fund space as opposed to public markets. By
comparison, HG received a strong bid from multiple fronts including bank prop desks, crossover money
from the US and regional banks, which were sitting on low loan to deposits ratios (and excess reserves)
only eager to boost returns and sovereign wealth funds.
The recovery in Asian credit markets in 2009 differed significantly from the post-AFC recovery, which was
led by a solid economic recovery after asset prices were severely written down. Instead, in 2009, the feeble
economic recovery was mired in multiple mini-crises that began in Dubai and expanded to the Greek crisis,
which seemed to be revisited every year at it spiraled into the euro crisis, and in the US, the debt ceiling
prompted for the first time discussions of a possible US default – so it was loose monetary policies that led
the recovery in prices, while most of EM rode on the coattail of China's debt-fuelled investment growth.

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Today
Today, we feel that Asian credit markets are in a less-healthy position than in recent months, but the
impetus for spreads to sharply blow out is not necessarily present. The near-term technical issues to
consider are that inflows into EM assets have remained strong and steady as reflected in the monthly data
reported by the IIF and weekly data from EPFR. This has been offset by record issuance with YTD figures
standing at US$104bn (and well on pace to beat last year’s record of US$120bn), US financial conditions
appear to have dipped sharply recently, and dealer inventories of certain credit asset classes such as US
HY have started to build up, resulting in wider spreads and higher yields. Also, looking at the TRACE data
on Bloomberg, we see that, in the past 2 out of 3 weeks, dealers have been establishing long EM bonds
positions, presenting a slight worrisome sign. The combination of factors all set a negative backdrop for
Asian credit performance.

Exhibit 1. Bloomberg US financial conditions index

Source: Bloomberg

Exhibit 2. IIF Tracker: Total Portfolio Inflows into Emerging Markets

$ billion
60
50 Estimates
through
40 June
30
20
10
0
-10
-20
-30
-40
Jan 13 May 13 Sep 13 Jan 14 May 14
Source: Source: IIF, National Sources, EPFR, Bloomberg

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Exhibit 3. Weekly EM dealer to client net sales
Net dealer to client selling
700 52 week avg

600

500

400

300

200

100

-100
Jul-13 Oct-13 Jan-14 Apr-14
Source: Bloomberg

Relative to the somewhat weak negative technicals, the immediate fundamental backdrop also appears
mired in challenges. The US Citigroup Economic Surprise Index shows that the recent economic data
releases have been uninspiring. On the flip side, if job and wage growth were weighing on inflation, credit
markets would also have to contend with a rising US rates outlook. Away from the US, Europe and EM has
been contending with its fair share of negative fundamental issues. These include weak growth in the euro
area, with the potential taper bombs as witnessed by the headlines from Portugese bank Banco Espirito
Santo. On the EM front, further sanctions on Russia for its involvement in Ukraine and Austrian bank Erste
write downs from its exposure to Hungarian and Romanian assets are signs of the vulnerabilities in EM.
Perhaps the only saving grace to the recent string of disappointing fundamentals has been China’s growth
outlook, which was steadied by mini-stimulus programs and loose monetary policy (as also reflected in the
steadying in China’s repo rates).

Exhibit 4. US Citigroup Economic Surprise Index

Source: Bloomberg and Nomura

So the backdrop presents plenty of reasons to be cautious in the coming months but not enough to
necessarily cause a sharp sell-off.

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What to look for over the next 6 months…
In the near term, the Asian credit markets will be driven by earnings results, with China property being the
key vulnerable sector that is likely to under-deliver and hurt spread performance. This comes alongside the
final verdict on the Indonesian elections and India’s incoming government delivering a steady structural shift
in growth that will potentially finally reverse the Negative Outlook assigned by S&P. By comparison, the EM
backdrop for Asia is likely to be more murky, depending on how issues such as violence in Iraq led by ISIS
(which appears to have quietened down recently), Russia’s handling of sanctions and the Brazilian
presidential election (not helped by the poor performance at the World Cup) play out.
Moving into 4Q is where the real pressure starts to build, with the end of QE tapering from October.
Unfortunately, the last few years have shown that markets have reacted unkindly, crying for more QE after
the end of each program. But relative to 4Q 2014, we are perhaps more concerned with the outlook for
markets heading into 2015 and beyond.

Exhibit 5. S&P500 and 10-year UST yields versus history of QE

2100 S&P500 6.0

10-yr UST
1900
5.0
Operation
1700 QE1 QE2 Twist QE3
4.0
1500

1300 3.0

1100
2.0
900
1.0
700

500 0.0
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14

Source: Bloomberg and Nomura

… and over the subsequent 12 months

I would expect that the rise in EM volatility after QE tapering to be lower relative to the QE taper tantrum in
May 2013. Most sovereigns have built up better defenses through lower current account deficits and better
fiscal positions since then, providing a better buffer. Instead, the growth outlook for China and the ripple
effects on the rest of EM will matter much more, in my view. Consensus puts China’s growth at 7.4% in
2014 and 7.2% in 2015, but the quality of China’s growth has obviously come under greater scrutiny, and
remains dependent on government intervention through fiscal and monetary policies, at a point where
leverage across provincial and corporate sectors is high and industrial capacity across a number of sectors
remain in excess.
The biggest challenge to China’s growth outlook is if the current pace of decline in property prices and
volumes remains through 2015, which would further dampen overall growth and weigh on the government’s
measures to implement further infrastructure spending. In addition, the excess capacity in steel, heavy
machinery and auto sectors (amongst others) is likely to see a contraction in top lines and margins
following a brief respite (especially in steel with falling iron ore prices) at the moment.

5
For the rest of the region at the sovereign level, I would argue that most countries should, to varying
degrees, better withstand a China slowdown with most regional government’s having undertaken policies to
address large fiscal deficits (such as in Malaysia and to some extent India) while others have run much
more conservative balance sheets since the Asian financial crisis to withstand future shocks (such as Korea,
the Philippines, Indonesia and Thailand). This has been with a view to never returning to the IMF with cap
in hand. A second form of defense, the Chiang Mai initiative, should also provide another buffer.
Away from the larger sovereigns, the outlook for Mongolia and the possibility of the country returning to the
IMF could set the stage for the IMF testing its private sector bail-in program. So far, the IMF has been
criticized for inconsistency in the way prior bail-out programs have been handled. Nonetheless, if the new
framework is tested, a private sector bail-in could hurt the performance of other marginal EM credits over
time. Within the region, other countries with aggressive finances after Mongolia that stand out are Sri Lanka
and Pakistan, which could struggle to refinance the portion of private sector debt outstanding.
Outside of EM, the key risks will come from the rate outlook and rate-driven market volatility, alongside the
outlook for the US HY market. Fortunately, the outlook for rates remains benign, with only the short-end
likely to present challenges while the 1yr forward on the 10yr calls for only a 30bp rise from current levels,
suggesting a flattening of yield curves making the short-end of credit a tougher place to invest. The bigger
challenge for credit will be the path this rate normalization takes, and the volatility associated with it. This
will come down to a function of inflation expectations and central banks jaw-boning market expectations,
making the commentary from the Fed ever more important.

Exhibit 6. UST spot versus 1-yr forward rate curve

Source: Bloomberg and Nomura

In our mid-year outlook, I had indicated that the quality of US HY deals brought to market in terms of
leverage and covenants had sharply deteriorated recently. Any misfortune to the US economic growth
outlook would certainly weigh on projected default rates and reprice this sector. It would be questionable if
such a repricing would impact the relative value offered by EM credits and if crossover money would start to
demand a higher return for EM.

6
Exhibit 7. Debt/EBITDA ratio of US Leveraged Exhibit 8. CCC or Lower-rated Corporate Bond
Buyout Transactions Issuance

Source: IIF – Capital Markets Monitor June 2014 Source: IIF – Capital Markets Monitor June 2014

Exhibit 9. Moody's Covenant Quality Index Exhibit 10. Global Covenant-lite Loan and PIK
Bond Issuance

Source: IIF – Capital Markets Monitor June 2014 Source: IIF – Capital Markets Monitor June 2014

All in all, despite the risk factors present in 2015, what remains a certainty at this stage is that Asian credit
markets are set to continue to grow in size at a healthy clip in coming years. There are several drivers for
such growth. These include a bond market which remains underdeveloped relative to the size of the
economy when compared to its US and European peers. Funding from the banks is much tighter today
than it has been for a numbers of years, with loan-to-deposit ratios for most markets at fairly high levels.
Lastly, the refinancing needs in US$ are at their highest levels for a while, ensuring that a steady stream of
issuance will be brought to market by issuers. The maturing schedule for US$-denominated bonds should
increase from an estimated US$20bn pa in years gone by to over US$40bn pa given the rise in issuance
since 2009. The result is that we could still go through phases of indigestion, especially in a rising rate
environment where inflows into the asset class are certainly not assured, as we have seen in recent years.
From a sector standpoint, Korea and Hong Kong credits will undoubtedly remain the safe havens in the
HG market, while China will be driven by the volume of issuance and credit rating migration. Malaysian and
Thai credits are to remain locked away, offering limited opportunities, while Indian credits will likely continue
to flourish with issuance gathering momentum, similar to their Chinese peers. However, the prospects for
Indian credits to outperform remain strong, supported by the promise of an improving economic backdrop.
In the HY world, Philippine credits are likely to offer the most stability and a sharp widening should be
viewed as a buying opportunity. At the opposite end of the spectrum are China property bonds, which are
likely to generate the highest volatility given the direction of earnings and credit quality migration heading

7
south. Between the two extremes lie Chinese industrials and Indonesian HY bonds. Given limited issuance
from the industrial sector, volatility is likely to remain low with better technicals, but earnings could still
disappoint, resulting in sharp price changes where earnings forecasts are not well anticipated. By
comparison, the bifurcated nature of Indonesian credit, with solid blue chips to more credit intensive names
should ensure that lower-rated credits remain more vulnerable in the worst of times, generating
opportunities in any subsequent market recovery.

Irrespective of how markets pan out tomorrow, or over the next 18 months, perhaps I will be back one day
to stand corrected on the views I have laid out in this final note. Until then, the pleasure has been mine to
share my views regularly on markets.

8
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