Credit markets have had a tough start to 2022, with prevailing technical influences and ongoing credit themes now mixed with the return of geopolitical concerns following Russia’s invasion of Ukraine.
For now, credit implications for SGD credit will be indirect, with limited or manageable direct exposure to Russia and Ukraine. That said, the indirect impact from rising costs and tighter market liquidity will become more direct if the situation prolongs. Issuers from the finance and commodity sectors will have the most direct impact. However, we do not see an immediate impact on their fundamentals.
Challenging conditions so far
Credit markets have found it tough-going so far this year. Technical influences from inflation and the prospect of rising interest rates have hit valuations and caused a widening in credit spreads.
The Bloomberg Barclays Asia USD IG Bond Index average option-adjusted spread (OAS) was at 147 basis points (bps) at the time of writing, its widest point since the peak of the Covid-19 crisis in mid-April 2020. High-yield spread movements have been similar in direction, with the Bloomberg Barclays Asia USD HY Index average OAS rising above the 1,000bps mark to close at 1,025bps at the end of February and remaining at historically elevated levels (the HY Index average OAS averaged 845bps over the past 12 months with the 10-year average at 567bps).
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However, technicals paint only half the picture. Fundamental concerns are starting to swirl, mostly in the China credit space. Regulatory risk continues to be a concern, and spread-widening that was once mainly contained within high-yield developers is seen in other China sectors, other Asiadollar credit and even in the investment-grade space.
Most recently, technology companies have been bearing the brunt of the spreads. Alibaba Group Holding’s 10-year bond reached a record high last week. Bonds of Tencent Holdings and shopping platform Meituan are also dropping, according to Bloomberg.
China’s zero-Covid strategy has also hit consumer companies such as Macau casino SJM Holdings and hotpot chain Haidilao International Holding, whose credit ratings are under pressure amid a profit warning and the closing of more than 300 outlets last year.
See also: Russian Odesa missile strike tests Ukraine grain export deal
That said, China’s high-yield property continues to generate negative headlines, with broad-based stresses from tightening external market liquidity and constrained internal cash flow generation from declining sales volumes and concerns on the existence of off-balance sheet debts. Governance and liquidity concerns and the scale of undisclosed debt drove bonds for Logan Group Co to their lowest ever last week, with its LOGPH 5.25% ’23s sharply down and trading around 35 cents on the dollar at the time of writing. According to Bloomberg data, Logan and its subsidiaries must repay or refinance US$989 million ($1.29 billion) in local and offshore notes this year.
In addition, Shimao Group Holdings missed some trust payments on US$948 million of high-yield products and had its credit rating downgraded further as it has not reached an agreement to extend the repayments. Its Shimao 4.75% ’22s due July 3 also saw a sharp pricing downfall last week where it currently trades just below 50 cents on the dollar at the time of writing — a record closing low.
The Chinese government has given targeted help such as mortgage support in certain cities. Yet, it also reaffirmed that “houses are for living in, not for speculation and it won’t use the property market as short-term stimulus for the economy”.
The influence of geopolitics remains indirect for now
Pre-Covid-19, geopolitical tensions were prevalent between China and the US, and this had cast a shadow on credit markets then. While they have continued to boil in the background, Russia’s recent invasion of Ukraine threatens to cast an even larger shadow in the context of potential geopolitical black swan events.
For now, the identifiable impacts at this stage in the conflict appear to be:
- Higher commodity prices, with Russia a key global producer of oil and gas.
- Higher food prices as both Russia and Ukraine are key suppliers of agricultural goods such as wheat.
- Higher inflation as a result of higher commodity and food prices.
- Tighter financing conditions and market liquidity.
- Higher costs and more expensive financing to pressure corporate earnings.
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In general, these impacts will be indirect and are difficult to measure at this point. However, if the conflict becomes prolonged, the possibility for these indirect impacts to become direct will increase.
Manageable direct exposure to Russia and Ukraine
In the SGD credit space, we see manageable direct exposure to Russia and Ukraine as most companies should have negligible revenues or assets in the affected regions. Nevertheless, the lack of meaningful earnings generation from these countries also makes it a challenge to quantify the precise exposure as specific disclosures for geographies are not available. For example, Singapore Airlines includes Russia as part of Europe in its breakdown of passenger revenue by route region, along with Denmark, England, France, Germany, Italy, Spain, Switzerland, The Netherlands, and Turkey.
In our SGD coverage universe, the most obvious issuers with potential exposure are the European banks. Even then, it appears that direct risks are currently contained. The European Central Bank (ECB) recently stated that European financial institutions had effectively diversified away from Russia following Russia’s annexation of Crimea in 2014.
That said, the ECB has requested Eurozone banks and local regulators assess their exposures and risks to Russia as Western countries have promised sanctions over recent developments and echoed by supporting countries elsewhere. This includes Switzerland, which in a rare move, did not maintain its long-held neutrality. Issues regarding maintaining operations and impacts on loan books and liquidity should be assessed, both directly and indirectly from the sanctions. Since late January, the ECB has started warning Eurozone banks on possible sanctions risks from escalating tensions as well as the impact of heightened market volatility.
Financial institutions have been quick to clarify that the direct impact through balance sheet and operations will be somewhat limited, reinforcing the ECB’s earlier statements. Given rising sanctions risks, banks globally have also announced the winding back of any business lines connected with Russian issuers or investments.
Closer to home, all three Singapore banks — DBS Group Holdings, Oversea-Chinese Banking Corp and United Overseas Bank — have reportedly stopped issuing letters of credit involving Russian energy deals due to uncertainty over the course of sanctions. Several Chinese banks were also restricting financing for Russian commodity purchases.
In general, the earnings for financial institutions under our coverage are entrenched in their domestic markets where they maintain sizeable market positions and have domestic (and sometimes global) systemic importance.
Agri-commodities merchandiser, producer and trader Olam International also clarified its exposure given its operations in the Black Sea area, a major breadbasket region. The Black Sea belt is the world’s largest supplier of wheat. However, given the current uncertainty, Olam expects that demand would shift to India.
In addition, despite its wholly-owned subsidiary being one of the largest dairy producers in Russia, only around 1% of its 2021 consolidated sales volume and 0.8% of revenue are jointly attributed to Ukraine and Russia.
While sanctions have yet to affect foreign bank branches that the company banks with, Olam is prioritising the safety of its staff and their families in Ukraine. Sanctions are unlikely to hit the food sector according to management, but port operations are affected, which is likely to lead to short-term disruption in grain and edible oil.
Agribusiness company Wilmar International is also an SGD bond issuer with joint venture operations in Ukraine named “Delta Wilmar”. Operations at its processing plants have been suspended since Feb 24. A spokesman has indicated that the joint venture’s contribution to group profit is insignificant and the company’s top priority continues to be the safety of its employees.
In our view, direct Russian exposure is likely a very purposeful strategic choice for corporates, given the higher operating risk in Russia. According to Transparency International’s 2021 Corruptions Perceptions Index, Russia ranks 136th out of 180 countries. The World Bank scores Russia in the lowest quartile on average across four of the six Worldwide Governance Indicators including Control of Corruption and Rule of Law.
The spillover of conflict on other industries
Following on from the identifiable impacts of the conflict, other key sectors that will be influenced are somewhat outside those that are prevalent in the SGD space.
Commodities is an obvious sector that will be impacted given Russia’s position as a key global producer of oil and gas. There have already been significant developments with BP announcing earlier this week that it was abandoning its 19.75% stake in Rosneft Oil Company, Russia’s largest oil producer.
According to Reuters, Rosneft accounts for around half of BP’s oil and gas reserves and a third of its production. Rosneft’s largest shareholder is the Russian government with a 40.4% stake. BP’s divestment — most likely selling it back to the company or government — will reportedly result in US$25 billion in charges, although BP has stated that this development will not impact its short- and long-term financial targets as it moves away from oil and gas to low-carbon fuels and renewable energy as part of its strategy.
Similarly, Shell has announced it will exit its 27.5% stake in the Sakhalin-2 project, Russia’s first liquefied natural gas (LNG) project. Other oil and gas majors present in Russia include Exxon Mobil Corp which operates the Sakhalin-1 project and France’s TotalEnergies which is a partner in the Yamal LNG export project.
What the recent developments highlighted is the issue of energy security and energy nationalism. This could drive an expedited desire to develop domestic renewable energy sources for Russia’s top energy importers, thus ensuring ongoing future energy security and to comply with global sustainability as well as climate change goals.
For corporations such as BP that are heavily focused on sustainability and fulfilling key environmental, social and governance (ESG) targets, a move away from Russia (albeit likely more accelerated than planned) makes sense. As Russian oil and gas supplies become a less reliable energy source, we expect green energy producers to play a more important role in the medium to longer term.
The insurance sector may also be impacted. Swiss Re’s chief financial officer commented during its FY2021 results announcement last week that it was too early to assess potential exposure to losses in Ukraine, even though many insurance policies may have war-time exclusions. Swiss Re also indicated a modest exposure on the investment side and reinsurance business in both Russia and Ukraine.
Finally, the defence and cybersecurity sector may see higher income from increased spending. All major defence companies have a cybersecurity arm, and these are very likely where the direct spending will come from governments and military clients.
Cybersecurity spending was already on the rise before the conflict among corporate clients and the threat of cyberwar may bring forward spending and add to demand. Before the current conflict, Gartner, a technological research and consulting firm, projected global IT spending to grow by 5.1% y-o-y in 2022 to US$4.5 trillion and another 5.0% in 2023 to US$4.7 trillion. Among these, spending on enterprise software is projected to grow by 11% y-o-y in 2022 to US$671.7 billion and 11.9% y-o-y in 2023 to US$751.9 billion.
Cybersecurity firms are more acceptable to a broad range of investors from a humanitarian and/or ESG standpoint vis-à-vis defence companies as these companies are highly likely directly linked to weapons-making. The Singapore Computer Emergency Response Team (SingCERT, part of the Cyber Security Agency of Singapore) has advised companies to strengthen vigilance and online defences to protect themselves amidst the escalating conflict. At this point of the escalation, no major corporations have announced their cybersecurity spending plans yet.
Maintaining the spotlight on fundamentals
The Russia-Ukraine conflict has added further pressure to credit markets amongst ongoing themes of tightening market liquidity and regulatory risk. This is also in the context of operating conditions that are recovering from the Covid-19 pandemic.
While direct impacts appear manageable for now, the identifiable impacts are likely to lead to the indirect credit impacts of higher operating expenses and more expensive financing costs that will pressure earnings. This will enhance the importance of key credit fundamental influences:
- On the business side, a strong and defendable market position will allow corporates to pass on the higher costs to customers.
- From a financial perspective, a conservatively leveraged balance sheet or strong liquidity through either stable cash flows from earnings or access to committed external financing.
Andrew Wong, Ezien Hoo, Wong Hong Wei and Su-N Toh are credit analysts with OCBC
Photo: Bloomberg
