Chief Investment Office WM 30 June 2014

Emerging market bonds

Be more selective as valuations
grind tighter
Valuations slightly expensive: Emerging markets' sovereign and
corporate credit has moved into slightly expensive territory, with
spreads currently standing at 280 bps and 295 bps, respectively.
Tight valuations, coupled with a likely rise in the US yield curve over
6-12 months, lead us to become more selective when investing in
EM credit. We also advise investors to consider switching out of low-
yielding, expensive credits to credits that still offer attractive yields
while exhibiting solid external balance sheets.
Sovereign credit: In Eastern Europe, the Middle East and Africa,
we suggest that investors switch out of Polish to Hungarian
sovereign bonds as the latter offers a higher carry and a
stronger improvement on its external balance. In Latin America,
we recommend investors to switch out of Chilean and Peruvian
sovereign bonds, which trade expensively, to Colombia and Mexico.
The latter sovereigns are driven by higher exposure to the growth
pickup in the US, exhibit healthy external balances, and offer more
attractive valuations. We remain cautious of Argentina, given the
substantial risk of a default in the coming weeks.
Corporate credit: We still prefer export-oriented companies with
a diversified revenue base and the ability to generate hard-currency
revenues. We particularly like some Brazilian exporters, which are
better positioned than their domestically focused peers during times
of weak economic growth. We also like Mexican majority-state-
owned companies that benefit from the country's ongoing energy
reform. We have become more positive on Chinese property and
Russian issuers, but still recommend being selective.
Sovereign credit
Valuations are grinding tighter
Emerging market (EM) sovereign bond valuations have moved into slightly
expensive territory as spreads of the EMBI Global have narrowed by almost
50 basis points (bps) year-to-date (see Table 1), compressing by 20 bps just
over the last month. This leaves the EMBI Global trading at 280 bps over
US Treasuries.
Kilian Reber, analyst, UBS AG
kilian.reber@ubs.com
Alejo Czerwonko, analyst, UBS FS
alejo.czerwonko@ubs.com
Michael Bolliger, analyst, UBS AG
michael.bolliger@ubs.com
Tatiana Boroditskaya, analyst, UBS AG
tatiana.boroditskaya@ubs.com
This report contains contributions from
Donald McLauchlan, analyst, UBS FA; Monica
de la Grange, analyst, UBS AG; and Jeronimo
Mariscal, analyst, UBS AG.
Table of contents
Sovereign credit 1
Most favored 2
Closed recommendations 3
Least favored 4
Corporate credit 5
EMEA 5
Latam 7
Asia 8
Table 1: EM sovereign bond performance
Latam strongest, EMEA and Asia lagging
Year-to-date spread delta, total return and volatility
of EM sovereign bond segments
Spread
delta
Total
return
Volatility
(ann.)
EMBI Global -49 9.1% 3.4%
Investment Grade -27 8.0% 3.0%
High Yield -112 12.4% 6.4%
EMEA -47 7.4% 5.2%
Latin America -60 11.5% 4.5%
Asia -28 7.9% 2.7%
Source: Bloomberg, UBS, 26 June 2014
This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 12. Past performance is
no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in
this publication.
Looking across individual countries, most sovereign spreads are currently
trading relatively tight, based on the performance in the last 1 year as well
as 3 years.
A benign global rates environment, coupled with favorable investor sen-
timent, and some positive, albeit in our view short-lived, developments in
the high yield segment were largely responsible for this latest spread com-
pression.
Spreads to widen - selectivity is key
Looking ahead, however, we think higher trending US Treasury yields over
the next 6-12 months will lead to a renewed widening of sovereign spreads
as markets will again question the funding of sovereigns with current
account deficits. We thus recommend investors to switch out of sovereigns
that trade relatively expensively, both compared to their own history, and
also compared to their underlying fundamentals. Instead, we recommend
investors to switch to sovereigns that still provide a decent carry which will
support total returns, coupled with solid underlying fundamentals.
Switch to more attractive credits
Table 2 shows our sovereign preferences. In the Eastern Europe, the Middle
East and Africa (EMEA) region, we recommend investors to switch out of
Polish to Hungarian sovereign bonds as the latter offers a higher carry and
a stronger improvement on its external balances. In Latin America, we rec-
ommend investors to switch out of Chilean and Peruvian sovereign bonds,
which trade expensively, to Mexico and Colombia. The latter sovereigns are
driven by better exposure to the growth pickup in the US, exhibit healthy
external balances, and offer more attractive valuations. We remain cautious
of Argentina, given the substantial risk of a default in the coming weeks.
Our conviction that Indonesia will outperform its 'Fragile Five' peer Turkey
is reduced, given little prospects of a further reduction of its external imbal-
ances over the next 6 months. We regard South Africa as fairly valued after
its recent correction, and is now trading in line with its relatively weak fun-
damentals.
MOST FAVORED SOVEREIGN MARKETS
Hungary: Benefiting from ECB easing and scarcity value
We still regard Hungarian sovereign bonds as attractive from a total return
perspective, in particular given Hungarys healthy current account. We think
Hungary will be a beneficiary of the Eurozones continued easing stance
that was reaffirmed at the European Central Bank's June meeting. We
expect yields in Hungary to further compress in line with those of the
Eurozone periphery, where yields have narrowed by 145 bps year-to-date
(see Fig. 1).
Furthermore, we see scarcity value in Hungarys sovereign bonds denomi-
nated in hard currency, given that the Hungarian finance ministry plans to
gradually replace foreign debt issuance with local currency bond issuance.
Mexico: Energy reforms provide favorable backdrop
Banxico unexpectedly cut the reference rate by 50 bps in early June, trig-
gered by slower-than-expected growth in 1Q14. In our view, the rate
cut was not required given current economic conditions. Moreover, real
rates now are in negative territory, which increases potential volatility and
reduces the incentive to save. Still, we estimate Mexico's structural reforms
will add 75-175 bps to the country's structural GDP growth annually.
Table 2: Most and least preferred sovereigns
Ranked by regions: EMEA, Latin America, Asia
Most preferred Least preferred
Hungary Poland (new)
Mexico Peru
Colombia (new) Chile (new)
Indonesia (closed) Argentina
South Africa (closed)
Turkey (closed)
Source: UBS, 26 June 2014
The reference benchmark for our emerging markets sovereign bond strategy is
the JP Morgan EMBI Global. It consists of 61 countries, of which we cover most
of the important issuers. We expect our selection of most and least preferred
sovereigns to out- and underperform the EMBI Global, respectively, over a six-
month horizon.
Fig. 1: Hungary to benefit from ECB easing, in
line with Eurozone periphery
5-year bond yields in Hungary versus the Eurozone
periphery, in %
0
1
2
3
4
5
6
02-2013 05-2013 08-2013 11-2013 02-2014 05-2014
Hungary
Eurozone periphery (Italy, Ireland, Portugal, Spain)
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 2
The energy bill should increase foreign direct investment in the oil, gas
and electricity sectors in the next five years. Pending regulations need to
be approved in the coming weeks. The scheduled approval should further
benefit quasi-sovereign issuers in the energy sector, which make up 45%
of the Mexican sovereign's share in the EMBI Global index.
Recently, Pemex received a credit rating upgrade by Moody's to A3 from
Baa1, reflecting the sovereign upgrade in February 2014. We expect further
sovereign credit rating upgrades in the next 12-18 months on the back of
the energy reforms, while we regard the current yield pickup that the quasi-
sovereign credits in the energy sector offer over the sovereign as attractive.
We believe quasi-sovereign spreads to the sovereign should tighten by
another 10-15 bps (see Fig. 2), and settle within a range of 25-40 bps in
the case of Pemex, and 40-65 bps in the case of CFE.
Monica de la Grange, analyst, UBS AG
Jeronimo Mariscal, analyst, UBS AG
Colombia: Cyclical acceleration helped by political continuity
The Colombian economy has been accelerating in recent quarters and sen-
timent in the business sector is picking up (see Fig. 3). These improve-
ments are linked to increased investment in infrastructure and housing,
both driven by government policy initiatives. President Juan Manuel Santos
won a new four-year term on 15 June and obtained a vote of confi-
dence to continue negotiations with the guerrilla groups to try to achieve a
peace agreement. His re-election ensures the continuity of current orthodox
macro policies. We expect the Colombian sovereign to outperform simi-
larly-rated LatAm peers in the next six months. Colombia also displays solid
fundamentals. At 35.7% in 2014, government debt to GDP is expected to
remain comfortably below the average of BBB-rated peers (40.5%), and
the country's fiscal accounts are expected to exhibit a mild deficit of 1.3%
of GDP. Although Colombia is expected to post a current account deficit of
3.2% of GDP in 2014, most of this is covered by foreign direct investment
flows.
CLOSED RECOMMENDATIONS
South Africa: Fairly priced for weak fundamentals
In mid-June, S&P downgraded South Africa's long-term foreign currency
credit rating to BBB- from BBB, with a stable outlook. The same day, Fitch
lowered South Africa's credit rating outlook to negative from stable, with
an unchanged long-term foreign currency issuer default rating of BBB. We
use these rating actions as a trigger to take profit on our least preferred
recommendation on South Africa's USD-denominated sovereign bonds. At
current levels, we think the likelihood for further underperformance versus
investment grade peers over a six-month investment horizon is rather small.
However, we keep our cautious longer-term outlook given a depressed
structural growth outlook, high structural unemployment, highly leveraged
consumers, a lack of foreign investment, and sizable fiscal and current
account deficits.
Michael Bolliger, analyst UBS AG
Turkey: Improved funding conditions
Since we added Turkey to our list of least preferred sovereign issuers in
February, which we expected to underperform Indonesia, Turkey's funda-
mentals have improved slightly. Growth has held up relatively well, and was
driven by a shift toward export-oriented sectors in 1Q14.
Fig. 2: Mexican quasi-sovereign spreads should
tighten toward 40 bps versus the sovereign
Quasi-sovereign yield-to-maturity spread to the
sovereign (in bps)
40
50
60
70
80
90
100
110
Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14
Source: Bloomberg, UBS, 26 June 2014
Fig. 3: Colombia is enjoying a cyclical acceler-
ation
Industrial production and retail sales, yoy in %
-5
0
5
10
15
20
25
J
a
n
-
1
0
J
u
l
-
1
0
J
a
n
-
1
1
J
u
l
-
1
1
J
a
n
-
1
2
J
u
l
-
1
2
J
a
n
-
1
3
J
u
l
-
1
3
J
a
n
-
1
4
Industrial production Retail sales (rhs)
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 3
At the same time, Turkey has shown a gradual adjustment of its current
account balance, which we expect to continue over the coming quarters.
Hence, we think Turkey is less likely to underperform its 'Fragile Five' peer
Indonesia over the coming months. We therefore remove Turkey from our
list of least preferred issuers for now. We note that a key risk for Turkish
sovereign credit would be a sustained rise in the price of oil due to ongoing
tensions in Iraq. Also, the return to a more expansionary monetary policy
stance by the Central Bank of Turkey increases the risk of renewed bouts
of higher asset price volatility.
Michael Bolliger, analyst UBS AG
Indonesia: Weaker fundamental outlook
Since mid-2013, Indonesia has been the leader of the 'Fragile Five' group
- made up of Brazil, India, Indonesia, South Africa, and Turkey - in terms
of reducing its external imbalances. Indonesia hiked policy rates by 175
bps in 5 consecutive steps between June and November - ahead of all its
peers. Today, however, Indonesia has fallen behind, in our view. The new
parliament will likely be relatively fragmented, and a strong winner may
not emerge from the presidential elections due on 9 July. It will thus be
hard for any new president of Indonesia to introduce unpopular measures,
such as fuel price hikes, that are necessary to improve the country's external
balances. We thus close our most preferred recommendation for Indonesia.
LEAST FAVORED SOVEREIGN MARKETS
Poland: Unattractive total returns, consider switching
While Poland is a solid sovereign issuer, rated A-/A2/A- (S&P/Moody's/
Fitch), its total return outlook is relatively unattractive at current levels.
With yields compressing to below 100 bps over US Treasuries on the EMBI
Poland (see Fig. 4), and limited further spread compression potential, the
total return outlook for Polish sovereign bonds is low. We thus recommend
investors to consider switching out of Polish to Hungarian sovereign
bonds. Both sovereigns' fundamentals are driven by their export-orien-
tation toward the Eurozone, and in particular to Germany, but Hungary
should benefit more strongly due to its stronger trade openness. At the
same time, we believe the total return outlook of Hungarian sovereign
bonds is more attractive.
Argentina: Forced to the negotiating table, but risks remain tangible
The US Supreme Court on 16 June rejected Argentina's hearing petition
in the pari passu case, leaving intact the lower court ruling that Argentina
must pay holdouts in full if it pays exchange bondholders. The market
assumes Cristina Kirchner has the incentive to orchestrate a settlement with
holdouts, which is also our base case. Execution risks abound, however,
and the sovereign could fall into an extended period of default. Sovereign
spreads do not adequately price in the probability of a default over the
next six months, in our view. In addition, Argentina's fundamentals remain
weak. The economy is heading into recession (see Fig. 5) as consumers
are getting hit by higher borrowing costs, lower subsidies, and lower real
wages. Inflation stands close to 40% a year, according to the price index
compiled by the National Congress.
Peru: Commodity-induced slowdown
Economic activity has been slowing in Peru, with GDP growth dropping to
5% in 2013 from 6.3% a year earlier. The softening of activity seems to
have a cyclical (see Fig. 6) as well as a structural component as Peru's terms
of trade have been deteriorating in recent months and external funding
conditions have become less favorable. Peruvian sovereign bonds exhibit
some of the longest durations in the EM sovereign credit universe and will
remain vulnerable to rises in US Treasury yields, which we expect to exceed
Fig. 4: Consider switching out of Polish to Hun-
garian sovereign bonds
Yields of EMBI Poland versus EMBI Hungary, in %
0
1
2
3
4
5
6
7
8
9
10
06-2011 12-2011 06-2012 12-2012 06-2013 12-2013
Hungary Poland
Source: Bloomberg, UBS, 26 June 2014
Fig. 5: Argentina's economic activity deterio-
rating rapidly
Argentina's official economic activity indicator
(2)
0
2
4
6
8
10
12
Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14
Economic Activity (%change YoY - Official data)
Source: Bloomberg, 26 June 2014
Fig. 6: Economic activity in Peru decelerating as
commodity prices decline
Peru GDP growth versus DJ-UBS commodity price
index
0
50
100
150
200
250
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
2000 2002 2004 2006 2008 2010 2012 2014
Peru GDP - y/y %change (lhs) DJ-UBS Commodity Index (rhs)
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 4
50 bps over the next six months from the current 2.50% on the 10-year
tenor. We thus regard Peruvian sovereign credit as relatively unattractive
for the next six months, since it is likely to underperform its similarly-rated
peers. However, Peru will remain a solid sovereign in its own right due to
its large stock of FX reserves and healthy public finances.
Chile: Economic deceleration and fiscal reform debate
Lower copper prices are affecting the country's terms of trade and
investment decisions in the mining sector as Chile struggles with high
electricity and labor costs. Uncertainty surrounding the potential conse-
quences of the fiscal reforms proposed by Michelle Bachelet is weighing on
investment decisions and economic activity more broadly. As a result, the
economy is on a decelerating trend with economic activity numbers drifting
lower since mid-2013 (see Fig. 7). In our view, Chilean sovereign bonds
will underperform similarly-rated LatAm peers in the next six months. Chile
remains, however, a solid sovereign. At only 12.6% in 2014, government
debt to GDP is expected to remain well below the average of A-rated peers
(50.5%), and the country's fiscal accounts are expected to exhibit a mild
deficit of 0.9% of GDP. Although Chile is expected to post a current account
deficit of 3.4% of GDP, most of this is covered by foreign direct investment.
Corporate credit
Within EM corporate credit, Latin America has registered the strongest per-
formance so far this year (see Table 3). At the same time, the volatility of
total returns in this region has been quite moderate. EMEA and Asia cor-
porate credit, on the other hand, has been lagging behind, largely due to
Russia-Ukraine tensions, as well as a more challenging backdrop for the
Chinese property sector, respectively. Interestingly, investment grade and
high yield bonds have also shown a very similar performance year to date.
Given the still-muted growth outlook in several emerging economies,
we prefer credits of export-oriented major companies. They have diver-
sified revenue bases that reduce their dependence on economic growth in
their home countries. At the same time, they can generate hard-currency
revenue during periods when EM currencies remain vulnerable to setbacks.
In this context, we particularly like certain Brazilian exporters, which are
better positioned than their domestically focused peers during times of
weak economic growth.
In line with our preference for the Mexican sovereign, we also like Mexican
majority-state-owned enterprises that should benefit from credit rating
upgrades on the back of the recent sovereign upgrade by Moody's. We
have become more positive on Chinese property issues, but still recommend
a selective investment approach to the sector. We have also become slightly
more positive on Russian issuers, based on the recent relaxation of tensions
between Russia and Ukraine. Investors can find issuer and bond-specific
recommendations in our Emerging Market Bond List.
Fig. 7: Economic momentum softening in Chile
as copper prices decline
Economic activity and businessman confidence, yoy
in %
47
49
51
53
55
57
59
61
63
65
0
2
4
6
8
10
12
14
J
a
n
-
1
0
J
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-
1
0
J
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-
1
1
J
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1
1
J
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-
1
2
J
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-
1
2
J
a
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-
1
3
J
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-
1
3
J
a
n
-
1
4
Economic activity indicator Businessman Confidence (rhs)
Source: Bloomberg, UBS, 26 June 2014
Table 3: EM corporate bond performance
Latin America in the lead, EMEA the weakest
region year-to-date
Year-to-date spread delta, total return and volatility
of EM corporate bond segments
Spread
delta
Total
return
Volatility
(ann.)
CEMBI Broad -21 6.2% 1.7%
Investment Grade -21 6.3% 1.7%
High Yield -21 6.1% 2.2%
EMEA -8 4.7% 4.0%
Latin America -31 8.2% 1.9%
Asia -17 5.6% 1.4%
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 5
EMEA: Russian banks return to Eurobond
market with EUR bonds
Russian bond spreads remain volatile: Since March this year, the per-
formance of Russian corporate debt has been affected by the geopolitical
uncertainty related to the Ukraine crisis. The bond spreads have become
volatile due to the inherent complexity of pricing in the geopolitical risk (see
Fig. 8). A certain compression of spreads on Russian corporate debt, which
took place in May-June, was to a degree driven by the absence of primary
issuance from Russia, several weeks of inflows into emerging market bond
funds, as well as the 'risk on' environment promoted by the ECB's easing
efforts announced in early June.
Russian banks remain on deteriorating credit outlook: As we pointed
out in the note 'Emerging market bonds: Prepare for a rise in global yields'
dated 20 May 2014, the banks, being predominantly domestically ori-
ented, are facing challenging domestic macro environment characterized
by slower growth, higher funding costs and a weaker ruble. The recently
released 1Q14 results of Russian banks under coverage were relatively
weak, in line with our view.
Banks' profit margins under pressure: Turning to the banking system
as a whole, the banks see their profit margins being increasingly under
pressure. Due to the ongoing Ukraine crisis, international debt markets
were effectively closed to Russian borrowers for most of MarchJune this
year. As a result, Russian banks saw an accelerated growth of corporate
loans as companies increasingly turned to domestic lenders to raise funds.
According to the Russian Central Bank, in 4M14 corporate lending growth
reached 8.1%, more than doubling versus the 3.2% growth seen in 4M13.
In contrast, retail lending continued to decelerate, reporting a growth of
4.6%, almost halving from the 8% growth seen in 4M13. We welcome
such a shift from the asset quality perspective, but note that corporate loans
have lower interest rates vs. retail loans, with such a shift putting pressure
on the profit margin. The profit margin also remains under pressure due
to the higher cost of funding linked to the Russian Central Bank's 200bps
interest rate hike. The availability of funding was negatively affected by
retail deposit outflows of 0.6% in 4M14 vs a growth of 6.7% in 4M13. In
our view, a reduction of retail deposits was linked to the increased uncer-
tainty in light of the Ukraine crisis. Notably, the banks saw an acceleration
of corporate deposit growth (9.1% in 4M14 vs 3.1% in 4M13), but these
deposits are usually a more volatile component of the funding base.
Russia banks reopen the markets with EUR-denominated issuance:
We note that in recent weeks, international debt markets have seen
the return of Russian borrowers, with three banks, namely Sberbank,
Gapzrombank and Alfa bank, placing EUR-denominated bonds. The cur-
rency choice, in our view, is driven not only by the need to fund EUR-denom-
inated transactions and a relatively low EUR reference rate vs USD reference
rate, but also by the uncertainty regarding the amount of demand for
USD bonds, particularly from US-based investors, given a relatively tougher
stance of the US on Ukraine-related sanctions against Russia. We would
not be surprised to see more debt issuance from Russian borrowers going
forward.
Despite deteriorating fundamentals, we remain comfortable with the ability
and willingness of the banks under coverage to service their outstanding
Eurobonds. We gain additional comfort from the willingness of the Russian
state to support key strategic entities in case of need. Note, however, that
Fig. 8: Russian corporate bond spreads widened
sharply versus EM corporate bond spreads
Spreads, in basis points
0
20
40
60
80
100
120
140
160
180
200
0
100
200
300
400
500
600
700
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
Delta (rhs) Russia CEMBI Broad
Source: Bloomberg, UBS, 26 June 2014
Fig. 9: Russian corporate bond yields still ele-
vated versus CEMBI Broad
Yields, in %
-0.5
0.0
0.5
1.0
1.5
2.0
0
1
2
3
4
5
6
7
8
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
CEMBI Russia CEMBI Broad Delta (rhs)
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 6
potential sanctions levied against a bank or a majority shareholder of a
bank would affect the bank's operations and its bonds negatively, including
servicing the bonds issued under international law. Please refer to our bi-
weekly publication "Emerging Markets Bond list" for the latest bond rec-
ommendations.
Tatiana Boroditskaya, analyst, UBS AG
Latin America: A mid-year review
Greater spread tightening, higher total returns: Latin American
(LatAm) corporates have enjoyed a relatively positive first half of the year.
As measured by JP Morgan's CEMBI Broad, year-to-date through 24 June,
LatAm tightened by 33 bps, outperforming the aggregate index, Asia, and
EMEA. During this same period of time, spreads for the CEMBI Broad index,
Asia and EMEA have narrowed by about 23 bps, 19 bps, and 11 bps, respec-
tively. When looking at year-to-date total returns (see Table 3), also through
24 June, LatAm credits again came on top with 8.2% versus 6.2% for
the CEMBI Broad index, 5.6% for Asia, and 4.7% for EMEA. Lower-than-
expected UST benchmark yields played in favor of longer duration LatAm,
while growth concerns out of China and the Russia-Ukraine situation neg-
atively affected Asia and EMEA, respectively.
Robust primary offerings: When it comes to primary market offerings,
LatAm may not have come in on top, but around USD 62.7bn in year-
to-date corporate debt placements may lead sell-side analysts to revise
upward their projections of about USD85bn for all 2014. Asian credits
placed USD 87.3bn, on track to meet sell-side projections of USD 142.9bn,
while CEEMEA sold USD 31.8bn. Of the USD 62.7bn of new corporate debt
issuance year-to-date, 70% or USD 44.1bn were investment grade rated
credit; quasi-sovereign non-financial issuers including regional national
oil companies (NOCs) Pemex, Petrobras, and Ecopetrol, represented USD
22.3bn, or about 50% of this particular ratings' bucket.
Energy reform-related secondary laws in Mexico and Pemex: As we
head into the second half of 2014, we believe that investors will focus
on the progress in the approval and gradual implementation of reform-
related pending secondary laws in Mexico, in particular those pertinent to
the energy reform.
We continue to regard Mexico's NOC as one of the main beneficiaries of
the energy reform, and believe that the spread-to-sovereign compression
that has taken place since the proposal was initially announced supports
our view. Over the last 12 months, Pemex's spread-to-sovereign has com-
pressed from low-to-mid triple digits depending on the maturity to about
42 bps, 45 bps, and 70 bps in five-, ten-, and 30-year bonds, respec-
tively. Historically, Pemex has traded over Mexico, and we expect that rela-
tionship to remain. However, we expect the differential to be reduced
to a premium demanded by investors to compensate for potential com-
modity price volatility and liquidity risk, which we believe should lie within
a 25-40bps range. Comisin Federal de Electricidad (CFE), the other major
quasi-sovereign beneficiary of the energy reform, should trade some 25 bps
wide to Pemex on lower secondary market liquidity.
Donald McLauchlan, analyst, UBS FS
Fig. 10: Latam corporate bond spreads in line
with EM corporate bond spreads
Spreads, in basis points
-50
-40
-30
-20
-10
0
10
20
30
40
50
0
100
200
300
400
500
600
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
Latam Delta CEMBI Broad
Source: Bloomberg, UBS, 26 June 2014
Fig. 11: Latam corporate bond yields just
slightly higher versus CEMBI Broad yields
Yields, in %
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0
1
2
3
4
5
6
7
8
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
CEMBI Latam CEMBI Broad Delta (rhs)
Source: Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 7
Asia-Pacific: Liquidity improves but funda-
mental challenges remain
Mini-stimulus lifts market mood for now: On 9 June, China's central
bank announced it would lower the reserve requirement ratio (RRR) for
banks that lend sufficiently to the agricultural sector and small and micro-
sized enterprises (SMEs). The scale of the RRR cut exceeded the market's
expectations as three large national banks and one leading urban bank
were included in the list of eligible banks.
Combining the latest cut with the one in April, which was targeted at
small rural banks and credit unions, the central bank has injected a total
of about CNY 200bn in liquidity, a relatively small amount but a symboli-
cally important move. CIO believes the policy measures so far will stabilize
China's economic growth in the second and third quarters of the year, but
stimulus effects will likely be short-lived and the ongoing property market
correction may continue to last for a while.
The Asian bond market held up well in the past month, with the JP Morgan
Asia Credit Index (JACI) up 0.6%. Spreads on JACI US dollar Asian cor-
porate bonds tightened across the investment grade (IG) and high yield (HY)
segments, driven by the decreasing market perception of a hard landing
scenario in China as well as the monetary easing in Europe. HY spreads
tightened by 42 bps mainly due to the good performance of Chinese
property bonds, while IG spreads tightened by 19 bps as investors con-
tinued to chase quality names in a persistently low interest rate envi-
ronment. However, we think current Asian bond valuations are rich relative
to fundamentals, and investors should stick to quality names and minimize
duration risk.
Growing onshore defaults will increase risk premium: Since the
beginning of the year, Chinese domestic media have reported a series of
credit events, including defaults on onshore bonds and trust loans, sus-
pension of bond trading, and corporate liquidity crises. So far, these credit
events have mostly involved SMEs with relatively weak credit ratings and
which are concentrated in cyclical sectors, i.e., mining and property devel-
opment. Nevertheless, the total amount of credit involved has exceeded
CNY 54bn, significantly higher than the previous credit-event peak in 2011,
when defaults were concentrated in export-oriented SMEs in specific areas.
We believe China's onshore credit market could face a downside risk in
2H14 due to reduced shadow banking channels and maturity peak-out.
This will likely push credit spreads higher in the offshore bond market, par-
ticularly high yield bonds in cyclical industries, but is unlikely to lead to a
systemic meltdown.
Property sales remain lackluster: The Chinese residential market has
continued to cool down in 2Q14. Total contract sales for the first five
months of the year dropped 9.2% year-on-year by floor area and 10.6%
year-on-year by sales value. There has been a mismatch between demand
and supply. On the one hand, buyers are expecting more price-cuts and are
thus standing on the sidelines; on the other hand, some developers are still
holding back launches in anticipation of a better second half. However, as
most developers are lagging behind their 2014 contract sales targets, we
believe price cuts will be inevitable for developers to boost sales. We believe
bondholders need to differentiate liquidity risk from long-term business risk
when investing in China's property sector. We see the sector as having low
liquidity risk in the near term as developers have raised more than USD
9.5bn in the offshore capital market so far this year similar to the level they
Fig. 12: Asian (JACI) credit spread has tightened
across the board
Spreads, in bps
0
100
200
300
400
500
600
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
JACI HY JACI IG JACI overall
Source: JP Morgan, Bloomberg, UBS, 26 June 2014
Fig. 13: Asian (JACI) yields slightly below CEMBI
Yields, in %
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0.0
0
1
2
3
4
5
6
7
8
07-2011 01-2012 07-2012 01-2013 07-2013 01-2014
Asia (JACI) CEMBI Broad Delta (rhs)
Source: JP Morgan, Bloomberg, UBS, 26 June 2014
Emerging market bonds
UBS CIO WM 30 June 2014 8
raised in the same period last year. Moreover, some large developers were
able to raise comparatively low-cost funding from the Hong Kong syndi-
cated loan market. However, we believe long-term business risk is rising
for developers that have aggressively expanded into China's low-tier cities
where inventory pressure is mounting and speculative demand is receding.
For buy-to-hold bond investors, we recommend large state-owned
investment-grade property developers with a demonstrable record of
access to funding through various cycles. China Overseas Land and
Investment (BBB+/Baa1/BBB+, stable), China Resources Land (BBB-/Baa3/
BBB-, stable) and Poly Real Estate Group (BBB-/Baa3 /BBB-, stable) continue
to be our most favored developers from a credit perspective. In addition, we
recently upgraded our recommendation on the short-dated senior bonds
of Longfor Property (BB+/Ba1/BB+, stable) and Shimao Property (BB/ Ba2/
BB, stable) as they offer attractive risk-return profiles. Both Longfor and
Shimao enjoy leading market positions in China's tier-1 and tier-2 cities
where demand is more sustainable, exhibit prudent financial management,
and command strong onshore funding access.
Finding value in bank capital structure and CNH: We see value down
the capital structure of Chinese and Indian banks as we believe spreads
between subordinated and senior debt will continue to narrow driven by
supportive demand dynamics and a stable credit outlook. Last month, we
rated as attractive CITIC International Bank and ICIC Bank bonds. Although
the offshore CNH bond market has been negatively affected by concerns
over CNY depreciation, we believe the risk is overplayed. CIO believes
China's solid balance-of-payments surplus warrants a modest appreciation
of the CNY against the US dollar over time. We see buying opportunities
in the short-dated CNH bonds of high quality issuers, such as AVIC Inter-
national bonds, which we view as attractive.
Alan Gao, analyst, UBS AG
Emerging market bonds
UBS CIO WM 30 June 2014 9
Appendix
Relative value of USD-denominated EM debt
Spreads over US Treasuries and issuer rating
Argentina
Brazil
Chile
Colombia
Ecuador
Egypt
Gabon
Ghana
Hungary
Lebanon
Malaysia
Mexico
Pakistan
Panama
Peru
Philippines
Poland
Russia
Serbia
South Africa
Sri Lanka
Turkey
Ukraine
Uruguay
Venezuela
Vietnam
Kazakhstan Indonesia
Lithuania
India
Jordan
China
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-
Source: Bloomberg, UBS, 26 June 2014
The above graph shows the relationship between EM sovereign issuer ratings and the spreads of their USD-denominated bonds.
The horizontal axis represents the issuer's credit rating, for which we use the average rating from Moody's and S&P. The vertical
axis shows the spreads, i.e. the difference in yield between EM bonds and US Treasuries. On average, the weaker the issuer's credit
rating, the higher the spread. We use a regression model to approximate the relationship between credit ratings and spreads. The
solid line represents the estimated result. The vertical distance provides an indication of whether a sovereign issuer is more expensive
(below the curve) or cheaper (above the curve) relative to its credit rating.
Emerging market bonds
UBS CIO WM 30 June 2014 10
Appendix
Agency Ratings
Rating Agencies Credit Ratings
S&P Moody's Fitch / IBCA Definition
AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality.
AA+ Aa1 AA+
AA Aa2 AA
AA- Aa3 AA-
Issuers have very strong credit quality.
A+ A1 A+
A A2 A
A- A3 A-
Issuers have high credit quality.
BBB+ Baa1 BBB+
BBB Baa2 BBB
I
n
v
e
s
t
m
e
n
t
G
r
a
d
e
BBB- Baa3 BBB-
Issuers have adequate credit quality. This is the lowest Investment Grade
category.
BB+ Ba1 BB+
BB Ba2 BB
BB- Ba3 BB-
Issuers have weak credit quality. This is the highest Speculative Grade category.
B+ B1 B+
B B2 B
B- B3 B-
Issuers have very weak credit quality.
CCC+ Caa1 CCC+
CCC Caa2 CCC
CCC- Caa3 CCC-
Issuers have extremely weak credit quality.
CC CC+
C CC
Ca
CC-
Issuers have very high risk of default.
N
o
n
-
I
n
v
e
s
t
m
e
n
t
G
r
a
d
e
D C DDD
Obligor failed to make payment on one or more of its financial commitments.
This is the lowest quality of the Speculative Grade category.
Emerging market bonds
UBS CIO WM 30 June 2014 11
Appendix
If you require information on UBS Chief Investment Office WM and its research products, please contact the mailbox ubs-cio-
wm@ubs.com (please note that e-mail communication is unsecured) or contact your client advisor for assistance.
Disclosures (30 June 2014)
Agile Property Holdings 12, Alfa Bank 12, 13, America Movil 6, 9, Banco Bradesco 9, Banco do Brasil 6, 12, 13, 14; Bank of China
Hong Kong 14; Baosteel 3, 6, 12, Braskem 9, Brazil 14; Cemex 2, 5, 9, 10, China 1, 6, 8, 12, 13, 14; China Citic Bank 6, 8, 12, 13,
China Dev Bank 14; China Merchants Bank 6, 8, 12, 13, China Merchants Holdings 1, 6, 12, China Overseas Land & Investment
8, 12, China Resources Land 8, 12, 13, CSN ADR (ON) 6, 9, Ecopetrol 9, Fibria 9, Gazprom 12, 13, Gazprom 12, 13, Gerdau 9,
ICICI Bank 9, Itau Unibanco Banco Multiplo 9, Longfor Properties 11, Petrobras (PN) 9, 12, 13, POLY REAL ESTATE GROUP 12, 13,
Rosneft 6, Rosneft 6, Sberbank 6, Sberbank 6, Shimao Property Holdings 6, 12, 13, Transneft 6, Transneft 6, Vimpelcom 4, 6, 9,
12, VimpelCom 4, 6, 9, 12, VimpelCom 4, 6, 9, 12, VTB 6, 7, VTB 6, 7,
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Emerging market bonds
UBS CIO WM 30 June 2014 12
Appendix
Disclaimer
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Emerging market bonds
UBS CIO WM 30 June 2014 13
Appendix
Disclaimer
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Version 03/2014.
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UBS FS and/or its affiliates trade as principal in the fixed income securities discussed in this report.
Emerging market bonds
UBS CIO WM 30 June 2014 14