Financial Pacific: Emerging Markets (third party) september 21.2010
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- 1. Kilian Reber, analyst, UBS AG Wealth Management Research 21 September 2010 Emerging market bonds Hungary: Downgrade a Risk, Default UnlikelyFig. 1: Hungarian sovereign bonds under pressures Hungary is at risk of being downgraded by the main rating agencies,Hungarian sovereign bond spreads over US Treasuries which all have a negative outlook on the sovereign due to its lack ofcompared to emerging market bonds financial safety net and debt levels close to 80% of GDP.s Even though such a downgrade is already priced in to a certain extent,800 it could put further downward pressure on Hungarian sovereign bond 700 prices, and we do not recommend newly investing in these bonds600 right now. However, a default is still highly unlikely, and we see no500 substantially increased risk for buy-and-hold investors.400s Hungary's debt woes are an isolated issue in the region, but300 investors might also shun other sovereign bonds in Central and Eastern Europe (CEE) temporarily. The resulting bouts of volatility200can be used as opportunities to build up exposure to more attractive 100 sovereign debt in the CEE region, such as Polish or Bulgarian0 sovereign bonds. 030405 06 0708 0910Hungary Emerging markets overallRelationship with IMF souringSource: Bloomberg, UBS WMR as of 20 September 2010 Hungary was one of the first countries to be given an emergency IMF/EU loan package in the midst of the financial crisis, receiving EUR 20bn to save its banking system and financial markets from collapse.In mid-July, however, Hungary's access to the EUR 6bn of outstanding funding was blocked on the grounds that the newly elected government was not doing 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 instead talk exclusively to the EU about further funding. However, as of yet there no new plans for a financial loan package have been announced. As Fig. 1 shows, Hungarian sovereign bonds have begun to suffer and now trade at a spread higher than the emerging market average. This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 4.
2. UBS Wealth Management Research21 September 2010 Emerging market bonds Risk of downgrade to sub-investment gradeFig. 2: Current Hungarian sovereign ratings Hungary has debt close to 80% of its GDP and no financial safety net, andForeign currency long-term issuer ratings for Hungary it may overshoot its budget deficit targets in 2010 and 2011. The country is thus now at risk of downgrades by Moody's, S&P and Fitch, all of whichRatingOutlook currently have a negative outlook on the Hungarian sovereign (see Fig. 2).Moody'sBaa1NegativeA one-notch downgrade by S&P would mean that Hungarian sovereign bonds S&P BBB-Negative would no longer carry an S&P Investment Grade rating, but instead trade as FitchBBBNegative junk 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.Source: Bloomberg, UBS WMR as of 20 September 2010 Even though Hungarian sovereign bonds have already strongly corrected in the past few months, such a downgrade could put further downward pres- sure on these bonds' prices.Rating review delayed until October municipal electionsFig. 3: Hungary is not Greece While Hungary's municipal elections on 3 October 2010 are currently delaying Debt-to-GDP and deficit levels of selected countries any credible government commitment to narrow the budget deficit, all three (2010 forecasts) rating agencies are expected to conclude their rating reviews for Hungary this year after October. Until the municipal elections have been concluded,250 we expect ongoing political noise from the government, hinting at taking upJapan Government Debt (% of GDP) talks with the IMF again in the near future, which will likely keep Hungarian200 assets volatile. As long as no credible commitment or action is undertaken by the Hungarian government, we assign little fundamental importance to150 such statements.GreeceItaly No new investments right now, but default is unlikely100 Hungary US France We recommend that investors refrain from new purchases of Hungarian Germany UKSpain sovereign bonds before the rating agencies have concluded their review or50Switzerland before the Hungarian government has been able to come to an agreement with the IMF and the EU on a new financial loan program. 00 -5 -10 -15Government Balance (% of GDP) However, even though Hungary has one of the highest debt-to-GDP ratios in emerging Europe, we regard it as extremely unlikely that the HungarianSource: Fitch, UBS WMR as of 20 September 2010 sovereign will default on its bonds. Hungary's debt level is nowhere near that of Japan, Greece or Italy, while its debt level is far from those of the US, the UK, Spain or France (see Fig. 3). We therefore do not advise buy-and-hold investors to sell their current Hungarian sovereign bond holdings.Bouts of regional volatility offer opportunities While Hungary's debt woes are an isolated issue in the region, investors may also temporarily avoid sovereign bonds of other Central and Eastern European countries if Hungary is downgraded.We still favor Bulgarian and Polish sovereign bonds in the region, due to their relatively good debt and economic fundamentals as well as attractive valua- tions. We think investors interested in building up exposure to the CEE region should use such bouts of temporary volatility to enter into such investments. Emerging market bonds - 2 3. UBS Wealth Management Research 21 September 2010 Emerging market bonds Appendix Rating AgenciesCredit RatingsS&PMoody# sFitch / IBCA Definition AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. AA+ Aa1 AA+ Investment GradeAAAa2AA Issuers have very strong credit quality.AA- Aa3 AA-A+ A1A+ A A2AIssuers have high credit quality. A-A3A-BBB+Baa1 BBB+Issuers have adequate credit quality. This is the lowest Investment GradeBBB Baa2BBBcategory.BBB-Baa3BBB-BB+Ba1BB+Issuers have weak credit quality. This is the highest Speculative Grade BBBa2 BBcategory.BB-Ba3BB-B+ B1B+ B B2 B Issuers have very weak credit quality. Non-Investment Grade B-B3B- CCC+Caa1 CCC+Issuers have extremely weak credit quality.CCC Caa2CCCCCC-Caa3 CCC-CCCC+ C CaCC Issuers have very high risk of default.CC- Obligor failed to make payment on one or more of its financial DC DDDcommitments. This is the lowest quality of the Speculative Grade category. Emerging market bonds - 3 4. 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