Executive Summary
The emergence of State-owned Enterprise (SOE) borrowing in international capital markets has been notable in the last decade. Since the Global Financial Crisis, SOEs have sought to diversify their funding away from local banks. As a result, SOEs, or quasi-sovereigns as they are often known to fixed income investors, now make up roughly half the opportunity sets in both the emerging sovereign debt and emerging corporate debt investment universes. Credit investing of any kind typically offers investors compensation for expected default losses. In addition, structural mispricing often results in a boost to the risk premium. In this paper we argue that the very structure of SOE debt results in a consistent additional risk premium that long-term investors should find attractive. We believe SOEs have consistently overpaid for realized idiosyncratic default risk to date. Further, we believe there are structural reasons that drive the chronic overestimation of SOE default risk, which in turn leads to mispricing and opportunity. In addition, we believe GMO, as a long-term investor in this space with its first SOE debt investment in 1994, has several structural strengths geared to help generate sustainable excess SOE debt returns.
The Emergence of SOE Debt: Why Does It Even Exist?
The great majority of SOE funding is domestically sourced by local banks.1 However, within the past decade, SOEs have chosen to diversify their funding sources by venturing into the international capital markets. As a result, SOE debt has become a significant part of the emerging sovereign and emerging corporate debt investment universes (See Exhibit 1).2 The determinant as to whether SOE debt will enter the sovereign or corporate index is its ownership. Those entities that are 100% government-owned go into the sovereign index and the rest find a home in the corporate benchmark. This is, of course, a largely arbitrary construct instituted by index providers and driven by legacy reasons.3
EXHIBIT 1: SOE DEBT IS A BIG COMPONENT OF BOTH EMERGING SOVEREIGN AND CORPORATE DEBT INDICES
*As of 7/31/20 | Source: J.P. Morgan, GMO
So, why wouldn't SOE shareholders, or governments, borrow directly to on-lend to SOEs, thereby bypassing the inflated SOE default risk premium? On the surface, EM sovereign and SOE borrowers could collectively slash their interest bill by roughly 30 basis points of their collective GDPs.4 Why don't governments do just this? Let us walk you through some of these reasons.
First, the Government Finance Statistics manual, which lays out the IMF's accounting rules, incentivizes governments to keep SOEs a going-concern and have them borrow on their own. When an SOE deemed viable – and a great majority are – borrows, the SOE's senior unsecured debt will not be reported as a contingent liability on a shareholding government's balance sheet. This omission flatters a sovereign's fundamental credit ratios. Better ratios, of course, lead to better public ratings, which ultimately lead to cheaper sources of sovereign financing. The key here is that an SOE needs to be a going-concern, which can be subjective in some corner cases.5 We estimate that if a typical SOE debt issuing EM country in the EMBI index were to take all SOE outstanding debt onto its own balance sheet, the debt to GDP ratio would increase by 15 points to 60%.6 By not doing so, we estimate a sovereign typically saves roughly 0.8% of GDP, a hefty number compared to the roughly 2.4% average interest to GDP ratio, thus leaving it with a much stronger credit profile.7 An added benefit, from the government's perspective, is that SOE debt issuance tends not to be governed by the same mechanisms that govern the stricter sovereign issuance, hence requiring no parliamentary approval.
Second, compelling economic rationale exists for a sovereign to let its SOE borrow on its own. As equity investors, sovereigns are incentivized to take on debt to boost their returns on equity. Contrast this with a government on-lending where this related-party transaction is most likely registered as an acquisition of non-financial assets in the same amount (the government will substitute borrowed cash for an increase in investments in the same amount). To better illustrate, let's consider a fictional commodity producer's credit ratios from the sovereign's perspective8 in the following two scenarios:
- In Scenario A, the SOE has no debt and is 100% funded by the sovereign.
- In Scenario B, the SOE is only partially funded with sovereign equity, borrowing the rest on a stand-alone basis, up to "simple" leverage of 5x. Further assume the sovereign receives a 100% dividend payout.9
In this example, the sovereign in Scenario A will have a marginal gain of 8% and marginal cost of 6%, pocketing 200 basis points. The sovereign in Scenario B, on the other hand, will have a marginal cost of 5% and marginal gain of 12%, pocketing 700 basis points. The difference can be explained by the following two reasons. First, the sovereign in Scenario B, having offloaded SOE debt from its balance sheet and thus improved its own credit ratios, enjoys a lower interest rate on its entire sovereign debt stock. Second, debt sitting on the SOE's balance sheet provides financial leverage for the shareholding sovereign, which then increases ROE by 50% from 8% as in the Scenario A case (see Exhibit 2).10 It is important to note that Scenario B only works so long as financial leverage on SOE balance sheets remain sustainable, which is the case most of the time.
Continue reading here.
