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 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 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, 1. 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