emerging market bonds: be more selective as valuations grind tighter

Chief Investment Office WM 30 June 2014

Emerging market bondsBe more selective as valuationsgrind tighter

• Valuations slightly expensive: Emerging markets' sovereign andcorporate credit has moved into slightly expensive territory, withspreads currently standing at 280 bps and 295 bps, respectively.Tight valuations, coupled with a likely rise in the US yield curve over6-12 months, lead us to become more selective when investing inEM credit. We also advise investors to consider switching out of low-yielding, expensive credits to credits that still offer attractive yieldswhile exhibiting solid external balance sheets.

• Sovereign credit: In Eastern Europe, the Middle East and Africa,we suggest that investors switch out of Polish to Hungariansovereign bonds as the latter offers a higher carry and astronger improvement on its external balance. In Latin America,we recommend investors to switch out of Chilean and Peruviansovereign bonds, which trade expensively, to Colombia and Mexico.The latter sovereigns are driven by higher exposure to the growthpickup in the US, exhibit healthy external balances, and offer moreattractive valuations. We remain cautious of Argentina, given thesubstantial risk of a default in the coming weeks.

• Corporate credit: We still prefer export-oriented companies witha diversified revenue base and the ability to generate hard-currencyrevenues. We particularly like some Brazilian exporters, which arebetter positioned than their domestically focused peers during timesof weak economic growth. We also like Mexican majority-state-owned companies that benefit from the country's ongoing energyreform. We have become more positive on Chinese property andRussian issuers, but still recommend being selective.

Sovereign creditValuations are grinding tighterEmerging market (EM) sovereign bond valuations have moved into slightlyexpensive territory as spreads of the EMBI Global have narrowed by almost50 basis points (bps) year-to-date (see Table 1), compressing by 20 bps justover the last month. This leaves the EMBI Global trading at 280 bps overUS Treasuries.

Kilian Reber, analyst, UBS [email protected]

Alejo Czerwonko, analyst, UBS [email protected]

Michael Bolliger, analyst, UBS [email protected]

Tatiana Boroditskaya, analyst, UBS [email protected]

This report contains contributions fromDonald McLauchlan, analyst, UBS FA; Monicade la Grange, analyst, UBS AG; and JeronimoMariscal, analyst, UBS AG.

Table of contents

Sovereign credit 1Most favored 2Closed recommendations 3Least favored 4

Corporate credit 5EMEA 5Latam 7Asia 8

Table 1: EM sovereign bond performance —Latam strongest, EMEA and Asia laggingYear-to-date spread delta, total return and volatilityof EM sovereign bond segments

Spreaddelta

Totalreturn

Volatility(ann.)

EMBI Global -49 9.1% 3.4%

Investment Grade -27 8.0% 3.0%

High Yield -112 12.4% 6.4%

EMEA -47 7.4% 5.2%

Latin America -60 11.5% 4.5%

Asia -28 7.9% 2.7%

Source: Bloomberg, UBS, 26 June 2014

This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 12. Past performance isno indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables inthis publication.

Looking across individual countries, most sovereign spreads are currentlytrading relatively tight, based on the performance in the last 1 year as wellas 3 years.

A benign global rates environment, coupled with favorable investor sen-timent, and some positive, albeit in our view short-lived, developments inthe high yield segment were largely responsible for this latest spread com-pression.

Spreads to widen - selectivity is keyLooking ahead, however, we think higher trending US Treasury yields overthe next 6-12 months will lead to a renewed widening of sovereign spreadsas markets will again question the funding of sovereigns with currentaccount deficits. We thus recommend investors to switch out of sovereignsthat trade relatively expensively, both compared to their own history, andalso compared to their underlying fundamentals. Instead, we recommendinvestors to switch to sovereigns that still provide a decent carry which willsupport total returns, coupled with solid underlying fundamentals.

Switch to more attractive creditsTable 2 shows our sovereign preferences. In the Eastern Europe, the MiddleEast and Africa (EMEA) region, we recommend investors to switch out ofPolish to Hungarian sovereign bonds as the latter offers a higher carry anda stronger improvement on its external balances. In Latin America, we rec-ommend investors to switch out of Chilean and Peruvian sovereign bonds,which trade expensively, to Mexico and Colombia. The latter sovereigns aredriven by better exposure to the growth pickup in the US, exhibit healthyexternal balances, and offer more attractive valuations. We remain cautiousof Argentina, given the substantial risk of a default in the coming weeks.Our conviction that Indonesia will outperform its 'Fragile Five' peer Turkeyis reduced, given little prospects of a further reduction of its external imbal-ances over the next 6 months. We regard South Africa as fairly valued afterits recent correction, and is now trading in line with its relatively weak fun-damentals.

MOST FAVORED SOVEREIGN MARKETS

Hungary: Benefiting from ECB easing and scarcity valueWe still regard Hungarian sovereign bonds as attractive from a total returnperspective, in particular given Hungary’s healthy current account. We thinkHungary will be a beneficiary of the Eurozone’s continued easing stancethat was reaffirmed at the European Central Bank's June meeting. Weexpect yields in Hungary to further compress in line with those of theEurozone periphery, where yields have narrowed by 145 bps year-to-date(see Fig. 1).

Furthermore, we see scarcity value in Hungary’s sovereign bonds denomi-nated in hard currency, given that the Hungarian finance ministry plans togradually replace foreign debt issuance with local currency bond issuance.

Mexico: Energy reforms provide favorable backdropBanxico unexpectedly cut the reference rate by 50 bps in early June, trig-gered by slower-than-expected growth in 1Q14. In our view, the ratecut was not required given current economic conditions. Moreover, realrates now are in negative territory, which increases potential volatility andreduces the incentive to save. Still, we estimate Mexico's structural reformswill add 75-175 bps to the country's structural GDP growth annually.

Table 2: Most and least preferred sovereignsRanked by regions: EMEA, Latin America, Asia

Most preferred Least preferredHungary Poland (new)

Mexico Peru

Colombia (new) Chile (new)

Indonesia (closed) Argentina

South Africa (closed)

Turkey (closed)

Source: UBS, 26 June 2014The reference benchmark for our emerging markets sovereign bond strategy isthe JP Morgan EMBI Global. It consists of 61 countries, of which we cover mostof the important issuers. We expect our selection of most and least preferredsovereigns to out- and underperform the EMBI Global, respectively, over a six-month horizon.

Fig. 1: Hungary to benefit from ECB easing, inline with Eurozone periphery5-year bond yields in Hungary versus the Eurozoneperiphery, in %

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Emerging market bonds

UBS CIO WM 30 June 2014 2

The energy bill should increase foreign direct investment in the oil, gasand electricity sectors in the next five years. Pending regulations need tobe approved in the coming weeks. The scheduled approval should furtherbenefit quasi-sovereign issuers in the energy sector, which make up 45%of the Mexican sovereign's share in the EMBI Global index.

Recently, Pemex received a credit rating upgrade by Moody's to A3 fromBaa1, reflecting the sovereign upgrade in February 2014. We expect furthersovereign credit rating upgrades in the next 12-18 months on the back ofthe energy reforms, while we regard the current yield pickup that the quasi-sovereign credits in the energy sector offer over the sovereign as attractive.We believe quasi-sovereign spreads to the sovereign should tighten byanother 10-15 bps (see Fig. 2), and settle within a range of 25-40 bps inthe case of Pemex, and 40-65 bps in the case of CFE.Monica de la Grange, analyst, UBS AGJeronimo Mariscal, analyst, UBS AG

Colombia: Cyclical acceleration helped by political continuityThe Colombian economy has been accelerating in recent quarters and sen-timent in the business sector is picking up (see Fig. 3). These improve-ments are linked to increased investment in infrastructure and housing,both driven by government policy initiatives. President Juan Manuel Santoswon a new four-year term on 15 June and obtained a vote of confi-dence to continue negotiations with the guerrilla groups to try to achieve apeace agreement. His re-election ensures the continuity of current orthodoxmacro policies. We expect the Colombian sovereign to outperform simi-larly-rated LatAm peers in the next six months. Colombia also displays solidfundamentals. At 35.7% in 2014, government debt to GDP is expected toremain comfortably below the average of BBB-rated peers (40.5%), andthe country's fiscal accounts are expected to exhibit a mild deficit of 1.3%of GDP. Although Colombia is expected to post a current account deficit of3.2% of GDP in 2014, most of this is covered by foreign direct investmentflows.

CLOSED RECOMMENDATIONS

South Africa: Fairly priced for weak fundamentalsIn mid-June, S&P downgraded South Africa's long-term foreign currencycredit rating to BBB- from BBB, with a stable outlook. The same day, Fitchlowered South Africa's credit rating outlook to negative from stable, withan unchanged long-term foreign currency issuer default rating of BBB. Weuse these rating actions as a trigger to take profit on our least preferredrecommendation on South Africa's USD-denominated sovereign bonds. Atcurrent levels, we think the likelihood for further underperformance versusinvestment grade peers over a six-month investment horizon is rather small.However, we keep our cautious longer-term outlook given a depressedstructural growth outlook, high structural unemployment, highly leveragedconsumers, a lack of foreign investment, and sizable fiscal and currentaccount deficits.Michael Bolliger, analyst UBS AG

Turkey: Improved funding conditionsSince we added Turkey to our list of least preferred sovereign issuers inFebruary, which we expected to underperform Indonesia, Turkey's funda-mentals have improved slightly. Growth has held up relatively well, and wasdriven by a shift toward export-oriented sectors in 1Q14.

Fig. 2: Mexican quasi-sovereign spreads shouldtighten toward 40 bps versus the sovereignQuasi-sovereign yield-to-maturity spread to thesovereign (in bps)

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At the same time, Turkey has shown a gradual adjustment of its currentaccount balance, which we expect to continue over the coming quarters.Hence, we think Turkey is less likely to underperform its 'Fragile Five' peerIndonesia over the coming months. We therefore remove Turkey from ourlist of least preferred issuers for now. We note that a key risk for Turkishsovereign credit would be a sustained rise in the price of oil due to ongoingtensions in Iraq. Also, the return to a more expansionary monetary policystance by the Central Bank of Turkey increases the risk of renewed boutsof higher asset price volatility.Michael Bolliger, analyst UBS AG

Indonesia: Weaker fundamental outlookSince mid-2013, Indonesia has been the leader of the 'Fragile Five' group- made up of Brazil, India, Indonesia, South Africa, and Turkey - in termsof reducing its external imbalances. Indonesia hiked policy rates by 175bps in 5 consecutive steps between June and November - ahead of all itspeers. Today, however, Indonesia has fallen behind, in our view. The newparliament will likely be relatively fragmented, and a strong winner maynot emerge from the presidential elections due on 9 July. It will thus behard for any new president of Indonesia to introduce unpopular measures,such as fuel price hikes, that are necessary to improve the country's externalbalances. We thus close our most preferred recommendation for Indonesia.

LEAST FAVORED SOVEREIGN MARKETS

Poland: Unattractive total returns, consider switchingWhile Poland is a solid sovereign issuer, rated A-/A2/A- (S&P/Moody's/Fitch), its total return outlook is relatively unattractive at current levels.With yields compressing to below 100 bps over US Treasuries on the EMBIPoland (see Fig. 4), and limited further spread compression potential, thetotal return outlook for Polish sovereign bonds is low. We thus recommendinvestors to consider switching out of Polish to Hungarian sovereignbonds. Both sovereigns' fundamentals are driven by their export-orien-tation toward the Eurozone, and in particular to Germany, but Hungaryshould benefit more strongly due to its stronger trade openness. At thesame time, we believe the total return outlook of Hungarian sovereignbonds is more attractive.

Argentina: Forced to the negotiating table, but risks remain tangibleThe US Supreme Court on 16 June rejected Argentina's hearing petitionin the pari passu case, leaving intact the lower court ruling that Argentinamust pay holdouts in full if it pays exchange bondholders. The marketassumes Cristina Kirchner has the incentive to orchestrate a settlement withholdouts, which is also our base case. Execution risks abound, however,and the sovereign could fall into an extended period of default. Sovereignspreads do not adequately price in the probability of a default over thenext six months, in our view. In addition, Argentina's fundamentals remainweak. The economy is heading into recession (see Fig. 5) as consumersare getting hit by higher borrowing costs, lower subsidies, and lower realwages. Inflation stands close to 40% a year, according to the price indexcompiled by the National Congress.

Peru: Commodity-induced slowdownEconomic activity has been slowing in Peru, with GDP growth dropping to5% in 2013 from 6.3% a year earlier. The softening of activity seems tohave a cyclical (see Fig. 6) as well as a structural component as Peru's termsof trade have been deteriorating in recent months and external fundingconditions have become less favorable. Peruvian sovereign bonds exhibitsome of the longest durations in the EM sovereign credit universe and willremain vulnerable to rises in US Treasury yields, which we expect to exceed

Fig. 4: Consider switching out of Polish to Hun-garian sovereign bondsYields of EMBI Poland versus EMBI Hungary, in %

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Fig. 5: Argentina's economic activity deterio-rating rapidlyArgentina's official economic activity indicator

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Source: Bloomberg, 26 June 2014

Fig. 6: Economic activity in Peru decelerating ascommodity prices declinePeru GDP growth versus DJ-UBS commodity priceindex

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50 bps over the next six months from the current 2.50% on the 10-yeartenor. We thus regard Peruvian sovereign credit as relatively unattractivefor the next six months, since it is likely to underperform its similarly-ratedpeers. However, Peru will remain a solid sovereign in its own right due toits large stock of FX reserves and healthy public finances.

Chile: Economic deceleration and fiscal reform debateLower copper prices are affecting the country's terms of trade andinvestment decisions in the mining sector as Chile struggles with highelectricity and labor costs. Uncertainty surrounding the potential conse-quences of the fiscal reforms proposed by Michelle Bachelet is weighing oninvestment decisions and economic activity more broadly. As a result, theeconomy is on a decelerating trend with economic activity numbers driftinglower since mid-2013 (see Fig. 7). In our view, Chilean sovereign bondswill underperform similarly-rated LatAm peers in the next six months. Chileremains, however, a solid sovereign. At only 12.6% in 2014, governmentdebt to GDP is expected to remain well below the average of A-rated peers(50.5%), and the country's fiscal accounts are expected to exhibit a milddeficit of 0.9% of GDP. Although Chile is expected to post a current accountdeficit of 3.4% of GDP, most of this is covered by foreign direct investment.

Corporate credit

Within EM corporate credit, Latin America has registered the strongest per-formance so far this year (see Table 3). At the same time, the volatility oftotal returns in this region has been quite moderate. EMEA and Asia cor-porate credit, on the other hand, has been lagging behind, largely due toRussia-Ukraine tensions, as well as a more challenging backdrop for theChinese property sector, respectively. Interestingly, investment grade andhigh yield bonds have also shown a very similar performance year to date.

Given the still-muted growth outlook in several emerging economies,we prefer credits of export-oriented major companies. They have diver-sified revenue bases that reduce their dependence on economic growth intheir home countries. At the same time, they can generate hard-currencyrevenue during periods when EM currencies remain vulnerable to setbacks.In this context, we particularly like certain Brazilian exporters, which arebetter positioned than their domestically focused peers during times ofweak economic growth.

In line with our preference for the Mexican sovereign, we also like Mexicanmajority-state-owned enterprises that should benefit from credit ratingupgrades on the back of the recent sovereign upgrade by Moody's. Wehave become more positive on Chinese property issues, but still recommenda selective investment approach to the sector. We have also become slightlymore positive on Russian issuers, based on the recent relaxation of tensionsbetween Russia and Ukraine. Investors can find issuer and bond-specificrecommendations in our Emerging Market Bond List.

Fig. 7: Economic momentum softening in Chileas copper prices declineEconomic activity and businessman confidence, yoyin %

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Table 3: EM corporate bond performance —Latin America in the lead, EMEA the weakestregion year-to-dateYear-to-date spread delta, total return and volatilityof EM corporate bond segments

Spreaddelta

Totalreturn

Volatility(ann.)

CEMBI Broad -21 6.2% 1.7%

Investment Grade -21 6.3% 1.7%

High Yield -21 6.1% 2.2%

EMEA -8 4.7% 4.0%

Latin America -31 8.2% 1.9%

Asia -17 5.6% 1.4%




EMEA: Russian banks return to Eurobondmarket with EUR bonds

Russian bond spreads remain volatile: Since March this year, the per-formance of Russian corporate debt has been affected by the geopoliticaluncertainty related to the Ukraine crisis. The bond spreads have becomevolatile due to the inherent complexity of pricing in the geopolitical risk (seeFig. 8). A certain compression of spreads on Russian corporate debt, whichtook place in May-June, was to a degree driven by the absence of primaryissuance from Russia, several weeks of inflows into emerging market bondfunds, as well as the 'risk on' environment promoted by the ECB's easingefforts announced in early June.

Russian banks remain on deteriorating credit outlook: As we pointedout in the note 'Emerging market bonds: Prepare for a rise in global yields'dated 20 May 2014, the banks, being predominantly domestically ori-ented, are facing challenging domestic macro environment characterizedby slower growth, higher funding costs and a weaker ruble. The recentlyreleased 1Q14 results of Russian banks under coverage were relativelyweak, in line with our view.

Banks' profit margins under pressure: Turning to the banking systemas a whole, the banks see their profit margins being increasingly underpressure. Due to the ongoing Ukraine crisis, international debt marketswere effectively closed to Russian borrowers for most of March–June thisyear. As a result, Russian banks saw an accelerated growth of corporateloans as companies increasingly turned to domestic lenders to raise funds.According to the Russian Central Bank, in 4M14 corporate lending growthreached 8.1%, more than doubling versus the 3.2% growth seen in 4M13.In contrast, retail lending continued to decelerate, reporting a growth of4.6%, almost halving from the 8% growth seen in 4M13. We welcomesuch a shift from the asset quality perspective, but note that corporate loanshave lower interest rates vs. retail loans, with such a shift putting pressureon the profit margin. The profit margin also remains under pressure dueto the higher cost of funding linked to the Russian Central Bank's 200bpsinterest rate hike. The availability of funding was negatively affected byretail deposit outflows of 0.6% in 4M14 vs a growth of 6.7% in 4M13. Inour view, a reduction of retail deposits was linked to the increased uncer-tainty in light of the Ukraine crisis. Notably, the banks saw an accelerationof corporate deposit growth (9.1% in 4M14 vs 3.1% in 4M13), but thesedeposits are usually a more volatile component of the funding base.

Russia banks reopen the markets with EUR-denominated issuance:We note that in recent weeks, international debt markets have seenthe return of Russian borrowers, with three banks, namely Sberbank,Gapzrombank and Alfa bank, placing EUR-denominated bonds. The cur-rency choice, in our view, is driven not only by the need to fund EUR-denom-inated transactions and a relatively low EUR reference rate vs USD referencerate, but also by the uncertainty regarding the amount of demand forUSD bonds, particularly from US-based investors, given a relatively tougherstance of the US on Ukraine-related sanctions against Russia. We wouldnot be surprised to see more debt issuance from Russian borrowers goingforward.

Despite deteriorating fundamentals, we remain comfortable with the abilityand willingness of the banks under coverage to service their outstandingEurobonds. We gain additional comfort from the willingness of the Russianstate to support key strategic entities in case of need. Note, however, that

Fig. 8: Russian corporate bond spreads widenedsharply versus EM corporate bond spreadsSpreads, in basis points

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Fig. 9: Russian corporate bond yields still ele-vated versus CEMBI BroadYields, in %

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potential sanctions levied against a bank or a majority shareholder of abank would affect the bank's operations and its bonds negatively, includingservicing the bonds issued under international law. Please refer to our bi-weekly publication "Emerging Markets Bond list" for the latest bond rec-ommendations.Tatiana Boroditskaya, analyst, UBS AG

Latin America: A mid-year review

Greater spread tightening, higher total returns: Latin American(LatAm) corporates have enjoyed a relatively positive first half of the year.As measured by JP Morgan's CEMBI Broad, year-to-date through 24 June,LatAm tightened by 33 bps, outperforming the aggregate index, Asia, andEMEA. During this same period of time, spreads for the CEMBI Broad index,Asia and EMEA have narrowed by about 23 bps, 19 bps, and 11 bps, respec-tively. When looking at year-to-date total returns (see Table 3), also through24 June, LatAm credits again came on top with 8.2% versus 6.2% forthe CEMBI Broad index, 5.6% for Asia, and 4.7% for EMEA. Lower-than-expected UST benchmark yields played in favor of longer duration LatAm,while growth concerns out of China and the Russia-Ukraine situation neg-atively affected Asia and EMEA, respectively.

Robust primary offerings: When it comes to primary market offerings,LatAm may not have come in on top, but around USD 62.7bn in year-to-date corporate debt placements may lead sell-side analysts to reviseupward their projections of about USD85bn for all 2014. Asian creditsplaced USD 87.3bn, on track to meet sell-side projections of USD 142.9bn,while CEEMEA sold USD 31.8bn. Of the USD 62.7bn of new corporate debtissuance year-to-date, 70% or USD 44.1bn were investment grade ratedcredit; quasi-sovereign non-financial issuers including regional nationaloil companies (NOCs) Pemex, Petrobras, and Ecopetrol, represented USD22.3bn, or about 50% of this particular ratings' bucket.

Energy reform-related secondary laws in Mexico and Pemex: As wehead into the second half of 2014, we believe that investors will focuson the progress in the approval and gradual implementation of reform-related pending secondary laws in Mexico, in particular those pertinent tothe energy reform.

We continue to regard Mexico's NOC as one of the main beneficiaries ofthe energy reform, and believe that the spread-to-sovereign compressionthat has taken place since the proposal was initially announced supportsour view. Over the last 12 months, Pemex's spread-to-sovereign has com-pressed from low-to-mid triple digits depending on the maturity to about42 bps, 45 bps, and 70 bps in five-, ten-, and 30-year bonds, respec-tively. Historically, Pemex has traded over Mexico, and we expect that rela-tionship to remain. However, we expect the differential to be reducedto a premium demanded by investors to compensate for potential com-modity price volatility and liquidity risk, which we believe should lie withina 25-40bps range. Comisión Federal de Electricidad (CFE), the other majorquasi-sovereign beneficiary of the energy reform, should trade some 25 bpswide to Pemex on lower secondary market liquidity.Donald McLauchlan, analyst, UBS FS

Fig. 10: Latam corporate bond spreads in linewith EM corporate bond spreadsSpreads, in basis points

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Fig. 11: Latam corporate bond yields justslightly higher versus CEMBI Broad yieldsYields, in %

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Asia-Pacific: Liquidity improves but funda-mental challenges remain

Mini-stimulus lifts market mood for now: On 9 June, China's centralbank announced it would lower the reserve requirement ratio (RRR) forbanks that lend sufficiently to the agricultural sector and small and micro-sized enterprises (SMEs). The scale of the RRR cut exceeded the market'sexpectations as three large national banks and one leading urban bankwere included in the list of eligible banks.

Combining the latest cut with the one in April, which was targeted atsmall rural banks and credit unions, the central bank has injected a totalof about CNY 200bn in liquidity, a relatively small amount but a symboli-cally important move. CIO believes the policy measures so far will stabilizeChina's economic growth in the second and third quarters of the year, butstimulus effects will likely be short-lived and the ongoing property marketcorrection may continue to last for a while.

The Asian bond market held up well in the past month, with the JP MorganAsia Credit Index (JACI) up 0.6%. Spreads on JACI US dollar Asian cor-porate bonds tightened across the investment grade (IG) and high yield (HY)segments, driven by the decreasing market perception of a hard landingscenario in China as well as the monetary easing in Europe. HY spreadstightened by 42 bps mainly due to the good performance of Chineseproperty bonds, while IG spreads tightened by 19 bps as investors con-tinued to chase quality names in a persistently low interest rate envi-ronment. However, we think current Asian bond valuations are rich relativeto fundamentals, and investors should stick to quality names and minimizeduration risk.

Growing onshore defaults will increase risk premium: Since thebeginning of the year, Chinese domestic media have reported a series ofcredit events, including defaults on onshore bonds and trust loans, sus-pension of bond trading, and corporate liquidity crises. So far, these creditevents have mostly involved SMEs with relatively weak credit ratings andwhich are concentrated in cyclical sectors, i.e., mining and property devel-opment. Nevertheless, the total amount of credit involved has exceededCNY 54bn, significantly higher than the previous credit-event peak in 2011,when defaults were concentrated in export-oriented SMEs in specific areas.We believe China's onshore credit market could face a downside risk in2H14 due to reduced shadow banking channels and maturity peak-out.This will likely push credit spreads higher in the offshore bond market, par-ticularly high yield bonds in cyclical industries, but is unlikely to lead to asystemic meltdown.

Property sales remain lackluster: The Chinese residential market hascontinued to cool down in 2Q14. Total contract sales for the first fivemonths of the year dropped 9.2% year-on-year by floor area and 10.6%year-on-year by sales value. There has been a mismatch between demandand supply. On the one hand, buyers are expecting more price-cuts and arethus standing on the sidelines; on the other hand, some developers are stillholding back launches in anticipation of a better second half. However, asmost developers are lagging behind their 2014 contract sales targets, webelieve price cuts will be inevitable for developers to boost sales. We believebondholders need to differentiate liquidity risk from long-term business riskwhen investing in China's property sector. We see the sector as having lowliquidity risk in the near term as developers have raised more than USD9.5bn in the offshore capital market so far this year – similar to the level they

Fig. 12: Asian (JACI) credit spread has tightenedacross the boardSpreads, in bps

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Source: JP Morgan, Bloomberg, UBS, 26 June 2014

Fig. 13: Asian (JACI) yields slightly below CEMBIYields, in %

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raised in the same period last year. Moreover, some large developers wereable to raise comparatively low-cost funding from the Hong Kong syndi-cated loan market. However, we believe long-term business risk is risingfor developers that have aggressively expanded into China's low-tier citieswhere inventory pressure is mounting and speculative demand is receding.

For buy-to-hold bond investors, we recommend large state-ownedinvestment-grade property developers with a demonstrable record ofaccess to funding through various cycles. China Overseas Land andInvestment (BBB+/Baa1/BBB+, stable), China Resources Land (BBB-/Baa3/BBB-, stable) and Poly Real Estate Group (BBB-/Baa3 /BBB-, stable) continueto be our most favored developers from a credit perspective. In addition, werecently upgraded our recommendation on the short-dated senior bondsof Longfor Property (BB+/Ba1/BB+, stable) and Shimao Property (BB/ Ba2/BB, stable) as they offer attractive risk-return profiles. Both Longfor andShimao enjoy leading market positions in China's tier-1 and tier-2 citieswhere demand is more sustainable, exhibit prudent financial management,and command strong onshore funding access.

Finding value in bank capital structure and CNH: We see value downthe capital structure of Chinese and Indian banks as we believe spreadsbetween subordinated and senior debt will continue to narrow driven bysupportive demand dynamics and a stable credit outlook. Last month, werated as attractive CITIC International Bank and ICIC Bank bonds. Althoughthe offshore CNH bond market has been negatively affected by concernsover CNY depreciation, we believe the risk is overplayed. CIO believesChina's solid balance-of-payments surplus warrants a modest appreciationof the CNY against the US dollar over time. We see buying opportunitiesin the short-dated CNH bonds of high quality issuers, such as AVIC Inter-national bonds, which we view as attractive.Alan Gao, analyst, UBS AG



Appendix

Relative value of USD-denominated EM debtSpreads over US Treasuries and issuer rating

Argentina

Brazil

Chile Colombia

EcuadorEgypt

Gabon

Ghana

Hungary

Lebanon

Malaysia

Mexico

Pakistan

Panama

Peru

PhilippinesPoland

Russia

Serbia

South Africa

Sri Lanka

TurkeyUkraine

Uruguay

Venezuela

Vietnam

Kazakhstan Indonesia

Lithuania

India

Jordan

China

0

100

200

300

400

500

600

700

800

900

1000

1100

1200

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B-


The above graph shows the relationship between EM sovereign issuer ratings and the spreads of their USD-denominated bonds.The horizontal axis represents the issuer's credit rating, for which we use the average rating from Moody's and S&P. The verticalaxis shows the spreads, i.e. the difference in yield between EM bonds and US Treasuries. On average, the weaker the issuer's creditrating, the higher the spread. We use a regression model to approximate the relationship between credit ratings and spreads. Thesolid line represents the estimated result. The vertical distance provides an indication of whether a sovereign issuer is more expensive(below the curve) or cheaper (above the curve) relative to its credit rating.



AppendixAgency Ratings

Rating Agencies Credit Ratings

S&P Moody's Fitch / IBCA Definition

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

AA+ Aa1 AA+

AA Aa2 AA

AA- Aa3 AA-

Issuers have very strong credit quality.

A+ A1 A+

A A2 A

A- A3 A-

Issuers have high credit quality.

BBB+ Baa1 BBB+

BBB Baa2 BBB

Inve

stm

ent

Gra

de

BBB- Baa3 BBB-

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

BB+ Ba1 BB+

BB Ba2 BB

BB- Ba3 BB-

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

B+ B1 B+

B B2 B

B- B3 B-

Issuers have very weak credit quality.

CCC+ Caa1 CCC+

CCC Caa2 CCC

CCC- Caa3 CCC-

Issuers have extremely weak credit quality.

CC CC+

C CCCa

CC-

Issuers have very high risk of default.

No

n-I

nve

stm

ent

Gra

de

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.



Appendix

If you require information on UBS Chief Investment Office WM and its research products, please contact the mailbox [email protected] (please note that e-mail communication is unsecured) or contact your client advisor for assistance.

Disclosures (30 June 2014)Agile Property Holdings 12, Alfa Bank 12, 13, America Movil 6, 9, Banco Bradesco 9, Banco do Brasil 6, 12, 13, 14; Bank of ChinaHong Kong 14; Baosteel 3, 6, 12, Braskem 9, Brazil 14; Cemex 2, 5, 9, 10, China 1, 6, 8, 12, 13, 14; China Citic Bank 6, 8, 12, 13,China Dev Bank 14; China Merchants Bank 6, 8, 12, 13, China Merchants Holdings 1, 6, 12, China Overseas Land & Investment8, 12, China Resources Land 8, 12, 13, CSN ADR (ON) 6, 9, Ecopetrol 9, Fibria 9, Gazprom 12, 13, Gazprom 12, 13, Gerdau 9,ICICI Bank 9, Itau Unibanco Banco Multiplo 9, Longfor Properties 11, Petrobras (PN) 9, 12, 13, POLY REAL ESTATE GROUP 12, 13,Rosneft 6, Rosneft 6, Sberbank 6, Sberbank 6, Shimao Property Holdings 6, 12, 13, Transneft 6, Transneft 6, Vimpelcom 4, 6, 9,12, VimpelCom 4, 6, 9, 12, VimpelCom 4, 6, 9, 12, VTB 6, 7, VTB 6, 7,

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Appendix

Disclaimer

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Appendix

Disclaimer

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emerging market bonds: be more selective as valuations grind tighter

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