Wavelength Credit Newsletter

Wavelength Credit Newsletter Emerging market corporates decoupling within emerging markets September 213 After a meaningful correction, emerging market corporates are starting to offer interesting investment opportunities against a backdrop of diverging growth trajectories of emerging market countries. Fundamentals While emerging market dynamics are changing and are not as universally positive as they have been, we believe valuations have meaningfully corrected over the last few months and are starting to offer interesting entry points. However, credit selection and endogenous emerging market specific considerations are increasingly important differentiating factors. The traditional emerging market growth model has changed. Easy growth driven by rising prices of commodity exports to supply China s low-cost production and its domestic capacity build out is no longer applicable. Many countries need to adjust their policies to drive domestic growth and address imbalances. The changing environment means a world where we are seeing decoupling within emerging markets. As countries cope with changes in their economies, the quality of government policy is increasingly important and will have a significant impact on their economies and the corporates domiciled therein. The traditional model has changed and there is a growing distinction between countries with good policies and surpluses and those with weaker policies and deficits. There is a growing distinction within emerging markets between those countries with current account and fiscal deficits and those with surpluses. Between those that are using the tools they have to undertake an appropriate policy response and those that are not. Some countries were more exposed to commodity exports than others and saved during the good times. Others had currencies appreciate on the back of higher commodity prices and easy money, but let government spending grow, while manufacturing productivity and government efficiency did not improve. The result was fiscal and current account deficits when commodity demand fell, expensive and uncompetitive manufacturing sectors and less flexible economies. Fundamentally, emerging market corporates have been affected by this transition, but the magnitude is not generally that material from a credit perspective. Most have strong enough balance sheets and sufficient liquidity to weather the transition. Emerging market corporate fundamentals have changed but remain relatively strong Leverage has increased on average by only.2x over the last year, remaining relatively low. For investment grade credits from 1.1x debt to EBITDA to 1.3x and from 2.5x to 2.8x for high yield credits over the past two years. These are levels which are generally lower than US credits of similar ratings (Fig. 1) and are manageable, particularly when factoring in higher growth rates than developed markets, notwithstanding its decelerated pace, and favourable demographics. We believe the scope to increase leverage further is likely to be limited both by the market and by management given the changing environment. Fig.1 EM versus US leverage Ra ng A BBB BB B Data source: Merrill Lynch, as at 3 June 213 Ratings trends are more in line with developed markets Trends are now mixed, but the average credit quality is higher than it has been in prior downturns and is actually in line with developed markets. After enjoying a period of net upgrades as emerging markets had been under-rated, emerging market ratings have more two-way risk. Some credits continue to be upgraded, but some also downgraded (largely in cyclical sectors). For investors in most markets this is normal and provides both opportunities and risks. While US credit is no longer in a net-downgrade trend, the average ratings are now similar to emerging market credits. In Brazil, for example, despite the macroeconomic challenges and sovereign spread widening this summer, three credits experienced positive rating actions (Fibria, a large forestry and pulp company; BancoBMG, a small bank; and Marfrig, a beef and protein company) as the companies continued to deliver good execution of their business plans and focused on improvement in credit quality. US EM Emerging market corporates Page 1

Conversely, two companies with weaker business plans (both roll-up companies), who grew through acquiring and combining smaller weaker companies, had negative rating actions as weak execution and decelerating growth led to deterioration in the credits in Brazil, Lupatech, an oil field services company, and Global A&T Electronics, a chip maker based in Singapore. Lupatech s weak business model could not sustain the slowing Brazilian economy and tighter monetary conditions. Global A&T was put on negative watch despite it being in a highly-rated country and US consumer demand improving. Fig. 2 USIG and HY credit rating migration 5-5 -1 Trailing 3mo ra ng migra on rate - US HY US IG -15 22 23 24 25 26 27 28 29 21 211 212 213 Fig. 3 EMEA IG and HY credit rating migrating (monthly) 4-1 -6-11 EMEA IG EMEA HY -16 Sep 9 Mar 1 Sep 1 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Data source: Merrill Lynch, as at 3 June 213 Data source: Merrill Lynch, as at 3 June 213 Fig. 4. Asia IG and HY credit rating migration (monthly) Fig. 5. LatAm IG and HY credit rating migration (monthly) 1 5-5 Asia IG Asia HY -1 Sep 9 Mar 1 Sep 1 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Data source: Merrill Lynch, as at 3 June 213 Data source: Merrill Lynch, as at 3 June 213 Defaults are below the historical average Ultimately, one of the most important barometers of credit risk is defaults, and we expect them to stay below historical averages. To date in 213 (3 June), the default rate is 1.6% in emerging market high yield corporates, though lower as a percentage of issuers with nine defaults out of some 7 issuers. This may grow to above 2% with one more likely default, OGX, but this is priced in with its bonds 8 6 4 2-2 -4-6 -8 LatAm IG LatAm HY -1 Sep 9 Mar 1 Sep 1 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 trading below 2 cents. This compares to a US high yield default rate of 1% year to date, and estimated to be just under 2% in 213 by JP Morgan. Historically, while the default rates in individual years have varied between US and emerging market high yield, the average default rate has been similar at approximately 3.6%, and there has tended to be a reversion to the mean. Looking forward, we expect emerging market high yield corporate defaults to be approximately 3.3% (2% excluding OGX) in our base case over the next twelve months, based on our bottom-up analysis. Emerging market corporates remain relatively strong and defaults are below historical averages. Fig. 6 EM corporate defaults year to date Issuer Country Region Magyar Telecom Hungary EM Europe Geo Mexico La n America Axtel Mexico La n America CEDC Russia EM Europe URBI Mexico La n America Lupatech Brazil La n America Homex Mexico La n America Maxcom Mexico La n America Agroton Ukraine EM Europe Fig. 7 Historical EM corporate default rate Region 24 25 26 27 28 29 21 211 212 YTD Asia.%.%.4%.%.6% 9.1% 1.5%.% 2.2%.% EM Europe.%.%.%.1%.9% 17.1% 1.6%.6% 4.5% 1.6% La n America.%.%.1%.% 4.3% 5.7% 1.7%.8% 2.5% 3.5% MENA 12.8%.%.%.%.% 4.7%.%.%.1%.% Default Rate % HY.1%.%.2%.% 1.9% 1.7% 1.5%.5% 2.7% 1.6% Data source: JP Morgan, as at 3 June 213 Data source: JP Morgan, as at 3 June 213 Valuations Valuations have corrected meaningfully and we see more decoupling While emerging market corporate fundamentals are not as strong as they were over the last few years, in parts of the market we feel this is already priced in, given the spread widening year to date. Page 2 Emerging market corporates

Emerging market corporate valuations have now priced out quantitative easing. In absolute terms, emerging market corporates as measured by the JP Morgan Corporate Emerging Market Bond Index (CEMBI) Diversified, have returned a negative 5.3 % year to date (to end August) with the investment grade and high yield segments of the asset class returning -5.7% and -4.3%, respectively. This has resulted in a 7.84% yield-to-maturity for high yield and 5.24% for investment grade. In spread terms, the JP Morgan CEMBI Diversified, (rated BBB) is trading at a spread of 349bps, which is 47bps wider than it was at the start of the year. The last time the index was trading at these yield levels, aside from a brief spike at the end of 211, was around June 21. On average 1-year liquid bonds have sold off 16 points, or more than 13bps in spread. Emerging market corporates have meaningfully underperformed their developed market peers in both absolute terms (3-4%) and in spread (2-5bps). As at 3 June the valuations of emerging markets versus developed markets were at their widest levels since 28. Investment grade rated credits are trading at 1.75x investment grade US, above its 1.25-1.35 average range (Fig. 9), while high yield corporates are trading at 1.45x the US versus a 1.15-1.25 average range (Fig. 1). By rating category, we believe that BBB and BB rated corporates offer the best value. BBB rated credits look the best value relative to their US peers at 1.75x, whilst BB rated credits trade at 1.7x their US counterparts. Geographically, we believe that BBB rated credits in Latin America and Europe stand out as cheap. Within BB rated credits, Asia stands out as providing good value. Fig. 8 Year to date comparative performance 8% 6% 4% 2% % -2% -4% -6% -8% -1% Data source: JP Morgan, Merrill Lynch, as at 12 September 213 Fig. 9 There is value in EM IG credits Fig. 1 There is value in EM HY credits 1.9 1.65 1.8 EM vs US IG Spread Ra o (x) EM vs US HY Spread Ra o (x) 1.55 1.7 1.45 1.6 1.35 1.5 1.4 1.25 1.3 Average 1.15 Average 1.2 1.5 1.1.95 Oct 9 Apr 1 Oct 1 Apr 11 Oct 11 Apr 12 Oct 12 Apr 13 Oct 9 Apr 1 Oct 1 Apr 11 Oct 11 Apr 12 Oct 12 Apr 13 Data source: JP Morgan, as at 3 June 213 Data source: JP Morgan, as at 3 June 213 Decoupling within emerging markets is increasingly evident Decoupling is evident within emerging market corporates by region (Fig. 11 & 12) as different countries face differing challenges, implement varying policy responses, and face different technicals. Some moves are merited, but there is often a tendency to over shoot. Investment grade rated credits in Latin America are trading at 1.8x that of similar rated credits in developed markets and offer the largest pickup over their sovereigns at 1.9x, while EMEA and Asia are closer to 1.7x. Emerging market country returns are decoupling from one another rather than moving as a group. Fig. 11 Latin American BBBs trade at 1.8x US BBBs Fig. 12 Year to date performance varies significantly by country Spread Ra o (x) 2. 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1. LatAm vs US BBBs EMEA vs US BBBs Asia vs US BBBs 4.% 2.%.% -2.% -4.% -6.% -8.% -1.% -12.% -14.% -16.% Peru Brazil Turkey Mex Colombia Indonesia Chile Phili India UAE China Russia Korea SING Qatar HK Ukraine Kazakh Data source: Merrill Lynch, as at 22 July 213 Source: JP Morgan, as at 3 August 213 Emerging market corporates Page 3

Technicals are becoming cleaner Fig. 13 EM corporate flows are stabilising In our view negative technicals in the second and third quarters 5 could turn more benign, which would improve asset class 4 performance. The sharp reversal in US rates, with the 1-year moving some 13bps higher from 1.6% to 2.9% in just two months as the market digested US Federal Reserve ( Fed ) tapering, caught many fixed income investors off guard. This resulted in negative 3 2 1-1 technicals as investment managers raised cash, spreads widened -2 to compensate for the increased volatility and investor inflows -3 EM Corporate Bond Funds turned into redemptions. With current yields higher and as the pace of rate moves moderate, flows have begun to stabilise (Fig. 13). In -4 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Apr-13 Jun-13 Aug-13 addition, many managers are sitting on higher cash balances based on a recent survey by Merrill Lynch, over 4% of clients are Data source: JP Morgan, as at 14 August 213 running a cash balance of around 8% and half are at their capped cash level. Therefore, we believe we could see a meaningful bounce in the performance of the asset class should the pace of outflows slow and rates stabilize. Weekly Fund Flows (US$mn) Risks Fed tapering and slower growth Risks do exist. However we feel those in our central case are already largely priced in (Fed tapering and slower growth). Meanwhile some risks are not priced in (the Fed hiking rates near term or an emerging market-specific crisis materialising), but these are unlikely scenarios. And, some perceived risks are greater than what is likely to be realized (FX depreciation impact on credit quality). How governments and corporates adjust their policies to the new global dynamics will likely be one of the main differentiating factors as we look forward. Fed tapering risk has diminished and is now less of an overhang than it had been. US growth continues to be slower than historical levels, and the fear priced into rates seems overdone given the 2 s - 1 s curve had steepened to historical highs (Fig. 14). In our view, the Fed will likely remain accommodative in the near term, which is supportive for fixed income generally and particularly for spread products such as emerging market corporates. Slower growth in emerging markets is already being felt and in large part is the cause of the recent underperformance of emerging market sovereign and corporate spreads. The adjustment process, while nascent, has already begun as currencies have depreciated and policy action adjusted. For most countries and companies, balance sheets are relatively strong in our view and flexible exchange rates should allow for a self-adjusting process to begin. US 2yr versus 1yr rates 3 2 1-1 -2-3 Sep-77 Current pricing compensates for expected Fed actions and base-case risks. Fig. 14 2 s - 1 s curve: at the steep end of the past 3 years Sep-79 Sep-81 Sep-83 Sep-85 Sep-87 Sep-89 Data source: Bloomberg, as at 12 September 213 Sep-91 Sep-93 Sep-95 Sep-97 Sep-99 Sep-1 Sep-3 Sep-5 Sep-7 Sep-9 Sep-11 Emerging market country crisis is unlikely to trigger contagion risk Recent weakness in emerging market currencies and other asset prices has fuelled concerns that a broader liquidity crisis is imminent, reminiscent of the Asia crisis in 1997, triggered by the reversal of QE flows as the US Federal Reserve tapers and then withdraws its stimulus. We believe these fears are exaggerated and note that the external vulnerabilities of emerging market countries are significantly reduced compared to previous crisis periods. There are still some major countries running sizable current account deficits, notably Brazil, South Africa, Turkey, India and Indonesia. Even here, however, we find that most of them are either already adjusting to tighter liquidity, through a combination of weaker exchange rates, weaker domestic demand (trimming the import bill) and stronger external demand (boosting export earnings), or have the tools and flexibility to adjust without sparking a major deterioration in the operating environment for their corporate sectors. To start with, FX regimes are now more flexible than in the 199s, and currency weakness is already doing some of the work of narrowing current account deficits where they are a concern. We estimate, for example, that the Real Effective Exchange Rates of India, Brazil and South Africa have depreciated by 2-25% since 211, with Turkey not far behind at 15%. Emerging market governments generally drew two further lessons from the Asian financial crisis and other stress episodes. First, the accumulation of large reserve buffers is a valuable tool if an economy is enjoying meaningful capital inflows. Total emerging market FX reserves now exceed US$8 trillion, compared to US$866 billion in 1996. Second, reliance on foreign currency borrowing is risky, whatever your currency regime. Accordingly, sovereigns have worked hard to develop their local markets and fund themselves in local currency wherever possible. As a result, even after strong foreign flows into local equity and debt markets, both before the global financial crisis and in the QE-fuelled enthusiasm for emerging markets that followed, external vulnerability indicators for most emerging market countries are significantly healthier now than in previous crisis periods. Page 4 Emerging market corporates

Federal Reserve rate hike is not expected This is a risk not priced in, but this is not in our central case. The recovery is still in the early stage in the US. Sequester impacts, potential debt ceiling debates and the threat of higher rates slowing the housing sector would still lead the Fed to be later rather than earlier in raising rates. The Fed has set a target of 6.5% unemployment, which current trend lines would imply is over a year away (Fig. 15). Local currency volatility impact on emerging market corporate 6 balance sheets seems manageable While investors fear that depreciating local currencies can lead to 5 a spike in emerging market corporate default rates, we think these concerns are overblown based on our analysis. Historically currency 4 moves have had a greater impact on corporates, because leverage was higher, debt tenor shorter and many countries had less flexible exchange rates. This did not allow for a gradual adjustment but Data source: Bloomberg, as at 31 August 213 rather pressure built up until it was either contained or snapped causing a crisis, with a large sharp depreciation of the currency and often currency conversion limits which meant even companies who had the earnings to service debt were not allowed to do so. We have reviewed the potential credit impact on our portfolio holdings of the recent depreciation of many emerging market currencies relative to the US dollar, and the impact is generally not material from a credit perspective. Most companies have relatively low leverage to begin with and many are either naturally hedged or have at least partially hedged the currency risk inherent in US-dollar denominated debt. Those which are impacted are domestically oriented businesses (e.g. telecoms and retailers), certain banks with either FX mismatches or securities holdings whose prices would be negatively impacted by the increase in local rates, and some individual credit stories. Fig. 16 Average leverage for portfolio holdings by sector and sensitivity to FX moves Fig. 15 US unemployment still above 6.5% US Unemployment rate total (%) 11 1 9 8 7 Aug-8 Nov-8 Feb-9 May-9 Aug-9 Nov-9 Feb-1 May-1 Aug-1 Nov-1 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Change in leverage Change in leverage 5% 1% 15% TMT.1x.2x.4x Consumer.1x.1x.2x Infra.1x.1x.2x Real Estate.x.1x.1x Industrial & Transport.x.1x.1x Oil & Gas IG.x.1x.1x U li es.x.x -.1x Metals & mining.x -.1x -.1x Pulp & Paper -.3x -.6x -1.x Change in leverage FX Loans % Change in Tier 1 capital 5% 1% 15% Deposits Total Banks Avg.%.%.% 14% 32% India.%.%.% 99% 86% Hungary -.1% -.1% -.2% 16% 74% Guatemala.%.1%.1% 136% 6% Peru.%.1%.1% 117% 52% Singapore.1%.3%.4% 88% 51% Colombia.%.%.1% 122% 31% Russia.%.%.% 97% 3% Turkey.%.%.1% 82% 27% Mexico.%.%.% 11% 1% Brazil -.1% -.1% -.2% 132% 1% Chile -.1% -.2% -.2% 89% 7% Source: BlueBay Asset Management Notes: 1 Leverage defined as net debt / EBITDA 2 For Banks we use Tier 1 capital percentage as measure of leverage 3 Internal estimates. Data used most recently available at June, which in most cases is 1Q13 Policy risk is likely to be a differentiating factor both between those that have maintained and will implement appropriate policies and those which do not. The impact of these policies will be more meaningful in some sectors or companies than others. Sovereigns Sovereigns generally have the tools to cope with the changing macro environment, as a mature country might do with a cyclical downturn. Reserves are generally high, leverage relatively low, with less external short-term debt than historically, while weaker currencies give flexibility to raise rates where necessary to curb domestic excesses. Governments however, must make orthodox policy decisions, rather Credit selection more important as differentiation increases. than popular short-term measures which can lead to larger issues down the road. Current account deficit countries with funding needs should for example allow currencies to depreciate and local rates to increase if this improves terms of trade, rather than supporting currencies in a manner that drains reserves simply to fund private purchases of consumption goods. Corporates On the whole corporates have good balance sheets and liquidity. Management should adjust the pace of CapEx to match new growth levels, which would increase cash flow and preserve liquidity. There are some companies with weaker business plans and overly high leverage or short-term debt, who were only able to issue due to easy credit conditions. These companies are likely to be at risk. Others have inherently good businesses, have been prudent in their deployment of capital and balance sheet management. These companies may experience a dip in earnings, but should remain sound from a credit perspective. Emerging market corporates Page 5

Conclusion As we have highlighted, after a meaningful correction, we believe emerging market corporates as an asset class look attractive to the well-informed investor. Emerging markets have recently come under pressure as a combination of tighter global monetary conditions and, in some cases, deteriorating fundamentals have hit confidence. However, as we have discussed, there is a growing distinction within emerging markets between those countries with current account deficits versus surpluses and those that are undertaking an appropriate policy response and structural reforms and those that are failing in their policy response. Mexico is a good example of a country where economic reforms are underway and the medium-term growth profile is improving. Meanwhile Indonesia and India highlight where the reform process needs to be prioritised. It is therefore difficult to make generalisations, but we note that overall emerging markets are in much better shape today than they were in prior times of stress. Sovereigns have much stronger balance sheets and a lower share of debt in foreign currency. Corporate debt maturities have been termed out and near-term payment pressures are modest. Within emerging market corporates there has been a deterioration in fundamentals across the more cyclical sectors. However, this has come from a relatively strong starting point. Spreads have also corrected and are now close to the recent wides when compared to similarlyrated corporates in the US. Our bottom-up default analysis projects a 1% default rate for the asset class (or 3.3% purely for the high yield segment), which is below the historical average and supports the case for spread compression over the course of the next 12 months. In the very short term we expect a round of supply in the primary market, which is likely to contain any near-term spread compression. Given our defensive stance, we expect to be able to capitalize on some of this new supply as it comes to market at what should be attractive levels (given the stagnation in the primary market over the last three months). Nevertheless, we maintain our constructive stance towards the asset class. Most countries and companies have strong balance sheets and do have the tools to navigate the current environment. In terms of asset class returns, in an environment of gradually rising US rates, and based on our default projections which suggest some compression in emerging market corporate spreads, we would expect a positive return within the asset class over the next twelve months. 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