Kilian Reber, analyst, UBS AG

Wealth Management Research 21 September 2010

Emerging market bonds

Hungary: Downgrade a Risk, Default Unlikely

■ Hungary is at risk of being downgraded by the main rating agencies,which all have a negative outlook on the sovereign due to its lack offinancial safety net and debt levels close to 80% of GDP.

■ Even though such a downgrade is already priced in to a certain extent,it could put further downward pressure on Hungarian sovereign bondprices, and we do not recommend newly investing in these bondsright now. However, a default is still highly unlikely, and we see nosubstantially increased risk for buy-and-hold investors.

■ Hungary's debt woes are an isolated issue in the region, butinvestors might also shun other sovereign bonds in Central andEastern Europe (CEE) temporarily. The resulting bouts of volatilitycan be used as opportunities to build up exposure to more attractivesovereign debt in the CEE region, such as Polish or Bulgariansovereign bonds.

Relationship with IMF souringHungary was one of the first countries to be given an emergency IMF/EU loanpackage in the midst of the financial crisis, receiving EUR 20bn to save itsbanking system and financial markets from collapse.

In mid-July, however, Hungary's access to the EUR 6bn of outstanding fundingwas blocked on the grounds that the newly elected government was notdoing enough to contain its budget deficit to 3.8% of GDP in 2010 and 3%in 2011. Shortly thereafter, Hungary decided to bypass the IMF and insteadtalk exclusively to the EU about further funding. However, as of yet thereno new plans for a financial loan package have been announced. As Fig. 1shows, Hungarian sovereign bonds have begun to suffer and now trade at aspread higher than the emerging market average.

Fig. 1: Hungarian sovereign bonds under pressureHungarian sovereign bond spreads over US Treasuriescompared to emerging market bonds

0

100

200

300

400

500

600

700

800

03 04 05 06 07 08 09 10

Hungary Emerging markets overall

Source: Bloomberg, UBS WMR as of 20 September 2010

This report has been prepared by UBS AG.Please see important disclaimers and disclosures that begin on page 4.

Risk of downgrade to sub-investment gradeHungary has debt close to 80% of its GDP and no financial safety net, andit may overshoot its budget deficit targets in 2010 and 2011. The countryis thus now at risk of downgrades by Moody's, S&P and Fitch, all of whichcurrently have a negative outlook on the Hungarian sovereign (see Fig. 2).

A one-notch downgrade by S&P would mean that Hungarian sovereign bondswould no longer carry an S&P Investment Grade rating, but instead trade asjunk bonds. This is important for bond holders because many institutional in-vestors would then no longer be able to hold these bonds in their portfolios.Even though Hungarian sovereign bonds have already strongly corrected inthe past few months, such a downgrade could put further downward pres-sure on these bonds' prices.

Rating review delayed until October municipal electionsWhile Hungary's municipal elections on 3 October 2010 are currently delayingany credible government commitment to narrow the budget deficit, all threerating agencies are expected to conclude their rating reviews for Hungarythis year – after October. Until the municipal elections have been concluded,we expect ongoing political noise from the government, hinting at taking uptalks with the IMF again in the near future, which will likely keep Hungarianassets volatile. As long as no credible commitment or action is undertakenby the Hungarian government, we assign little fundamental importance tosuch statements.

No new investments right now, but default is unlikelyWe recommend that investors refrain from new purchases of Hungariansovereign bonds before the rating agencies have concluded their review orbefore the Hungarian government has been able to come to an agreementwith the IMF and the EU on a new financial loan program.

However, even though Hungary has one of the highest debt-to-GDP ratiosin emerging Europe, we regard it as extremely unlikely that the Hungariansovereign will default on its bonds. Hungary's debt level is nowhere near thatof Japan, Greece or Italy, while its debt level is far from those of the US, theUK, Spain or France (see Fig. 3). We therefore do not advise buy-and-holdinvestors to sell their current Hungarian sovereign bond holdings.

Bouts of regional volatility offer opportunitiesWhile Hungary's debt woes are an isolated issue in the region, investors mayalso temporarily avoid sovereign bonds of other Central and Eastern Europeancountries if Hungary is downgraded.

We still favor Bulgarian and Polish sovereign bonds in the region, due to theirrelatively good debt and economic fundamentals as well as attractive valua-tions. We think investors interested in building up exposure to the CEE regionshould use such bouts of temporary volatility to enter into such investments.

Fig. 2: Current Hungarian sovereign ratingsForeign currency long-term issuer ratings for Hungary

Rating Outlook

Moody's Baa1 Negative

S&P BBB- Negative

Fitch BBB Negative

Source: Bloomberg, UBS WMR as of 20 September 2010

Fig. 3: Hungary is not GreeceDebt-to-GDP and deficit levels of selected countries(2010 forecasts)

Switzerland

France

ItalyGreece

Japan

SpainGermany UK

Hungary US

0

50

100

150

200

250

-15-10-50Government Balance (% of GDP)

Gov

ernm

ent

Deb

t (%

of

GD

P)

Source: Fitch, UBS WMR as of 20 September 2010

UBS Wealth Management Research 21 September 2010

Emerging market bonds

Emerging market bonds - 2

AppendixCredit Ratings

S&P Moody# s Fitch / IBCA Definition

AA+ Aa1 AA+

AA Aa2 AA

AA- Aa3 AA-

A+ A1 A+

A A2 A

A- A3 A-

BBB+ Baa1 BBB+

BBB Baa2 BBB

BBB- Baa3 BBB-

BB+ Ba1 BB+

BB Ba2 BB

BB- Ba3 BB-

B+ B1 B+

B B2 B

B- B3 B-

CCC+ Caa1 CCC+

CCC Caa2 CCC

CCC- Caa3 CCC-

CC CC+

C CC

CC-

D C DDDObligor failed to make payment on one or more of its financial

commitments. This is the lowest quality of the Speculative Grade category.

No

n-I

nve

stm

ent

Gra

de

Issuers have weak credit quality. This is the highest Speculative Grade

category.

Issuers have very weak credit quality.

Issuers have extremely weak credit quality.

Ca Issuers have very high risk of default.

Issuers have exceptionally strong credit quality. AAA is the best credit quality.

Issuers have very strong credit quality.

Issuers have high credit quality.

Issuers have adequate credit quality. This is the lowest Investment Grade

category.

Rating Agencies

Inve

stm

ent

Gra

de

AAA Aaa AAA

UBS Wealth Management Research 21 September 2010

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Emerging market bonds - 3

Appendix

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