Oi S.A.'s bankruptcy – the largest in the history of Brazil - is the latest example of geographic silos amplifying the very risk they seek to mitigate.
One of the key reasons people cite when allocating to a specific geography in the global high yield market is avoiding exposure to unwanted sovereign risk. We have long held the view that this is flawed reasoning in a rapidly globalising world where companies’ footprints cross borders and country risk can often be more heightened in the developed world than the emerging world.
Investors are increasingly choosing global allocations – already the global high yield money allocated to Europe exceeds the entire dedicated euro high yield market. Despite this, driven by regulation, red tape and aversion to change, flows have remained stubbornly siloed.
Even attempting to silo is proving futile in today’s global world. The euro high yield market has experienced two high profile bankruptcies in the last six months – Abengoa, and, this week, Oi S.A. Oi’s bankruptcy protection filing prompted bonds issued by its subsidiaries, including Portugal Telecom, Telemar Norte Leste and Oi Brasil, to tumble to record lows. In fact, the last bond to come from the company was sold to European high yield investors in June of last year. These 5 5/8s of 2021 never saw par during their 12-month run – the bonds are currently bid at around 10% of face value, a very low implied level of recovery reflecting a broader theme this cycle, which we have written about previously.
What is interesting about Abengoa and Oi, both high profile companies in this market, is that they are predominantly exposed to Latin America and other emerging markets, exactly the kind of exposure a euro allocation is looking to avoid.
Figure 1: The falling fortunes of Abengoa and Oi debt vs. increasing risk in Brazil
Value is relative
Both companies were very widely held by euro high yield and euro short duration funds, partly because, relative to the rest of Europe, they looked cheap at the point of issue. In hindsight, they looked cheap because it was not an apples for apples comparison. For example, a Brazilian company should either be compared to a Brazilian company, or to a close comparable that is then adjusted for the Brazilian premium. Without this, siloed investors will continue to be attracted to names that look cheap against an inappropriate universe of peers.
Adapting to the climate
By beginning with a global allocation, investors can selectively add risk where appropriate – for example, Russian steel companies have proven to be an excellent opportunity in the past 18 months when compared to developed market peers such as US Steel or AK Steel Ltd. But only by looking at the composition of sectors the way sectors look at themselves can one expect to successfully garner risk-adjusted returns and avoid blow-ups.
Latin America’s new liberals