Friday, 21 September 2018

IFR Top 250 2007: Local lessons

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With EM sovereigns reducing hard currency liability exposure and putting an increasing emphasis on their own markets, domestic debt has become a mainstay of international EM portfolios. Foreign investors have learnt lessons and profited nicely from rates and FX plays as comfort levels and experience with the asset class grows. Paul Kilby and John Weavers report.

EM managed to avoid what has become a "traditional" spring sell-off. Local markets comfortably outperformed external debt in the first months of 2007 with domestic bonds posting a 9.1% year-to-date gain in the first half of 2007 versus 2.9% for EM Eurobonds, before an early June correction triggered a bout of profit taking.

And even the early June sell-off was a comparatively painless affair as investors took a more mature approach toward local markets, instead of rushing for the exits all at once. "The difference this year is conviction," said Dario Pedrajo, senior fund manager at Kapax Investment Advisers. "The catalyst was the same, but the reaction was more mooted as people separated fear about higher US rates and the effect on local currencies and rates, which are in a different cycle."

Having gone through a similar slide last year when the US Treasury breached the 5% mark, investors in local markets had already explored the various outcomes and decided to stay put, said David Spegel, global head of EM strategy at ING. "This time a number of keen investors saw it as an opportunity and bought," he said. "It shows a familiarity with the risk. The second time around, shocks are not quite as shocking. It is the unexpected that throws investors."

A North America EM portfolio manager for a pension fund expressed similar views about investing in domestic currency debt. "Last year there was a lack of a large number of players, limited liquidity and less experience with the asset class," he said. "Players have done their homework [on the local markets] and they are there forever."

The resilience of local markets was highlighted when, amid the sell off in early June, Argentina was able to issue its first fixed-rate peso bond since the 2001 default, at rates that were tighter than expected. The 10.50% US$500m-equivalent five-year bond came at a yield of 11.70%. "Argentina was a big surprise. Everyone felt almost certain that rates were going to be north of 12%," said Pedrajo. "The Argentine peso didn't blink in the sell-off."

The increasing dominance of local markets and investors' heightened comfort levels with the asset class are consistently showing up in trading figures. Local instrument trading reached an impressive US$1.025trn or 60% of reported turnover in the first quarter, according to EMTA, the industry trade association. This compares with US$787bn in the first quarter of 2006, when local markets accounted for 48% of total turnover; and with US$935bn in the fourth quarter of 2006 when local instrument trading accounted for 57% of volume.

On a country basis, Mexico emerges as the clear leader, with US$336bn in trading volumes for that period, followed by Brazil (US$111bn), South Africa (US$101bn), Turkey (US$95bn) and Argentina (US$74bn). Mexico's supremacy is largely a reflection of that market's liquidity and openness, not to mention a well-developed and liquid local curve.

Brazil may seem like a natural candidate for the top spot, given that its market capitalisation represents 15% of the local fixed-income universe versus just 7% for Mexico, but the country's regulatory environment still makes it difficult to invest there, said Spegel.

According to Credit Suisse research, foreign investors have a total of around US$15.1bn invested in Mexican government securities, up from US$12.5bn a year ago. Holdings of government Treasuries – called Bonos – reached US$14.3bn by the end of May, jumping from just $11.8bn on April 27, when the Central Bank increased rates. "Foreign investors took advantage of the sell-off in rates to get into the market," said Alonso Cervera, senior LatAm economist at Credit Suisse.

In contrast to the increase in local markets instruments, Eurobond volumes in January–March, at US$639bn, declined 19% year-on-year and were down 4% compared to the fourth quarter of 2006 thanks in large part to increased use of derivative products such as CDS, rather than cash bonds, for short-term tactical trading.

As usual, Turkey local bonds have been the most volatile in EEMEA, suffering disproportionately during the February/March and early June corrections when the lira and T-bills sold off. Overall, however, Turkish local markets have enjoyed another strong year with the lira climbing almost 10% against the US dollar from 1.44 on January 1, while local benchmark yields are down nearly 300bp with July 2008s at in June 18.8% versus 22.55% at the start of the year.

The local bond rally has been driven by falling inflation expectations and hopes for CBRT easing in the second half of the year. Though annual CPI pushed back above 10% in the early months of the year, base effects should see inflation slow to just over 7% by year end, analysts believe.

"At the start of 2007 locals were significantly underweight the lira and T-bills due to concerns about the political outlook. Foreign investors boosted demand on lower inflation expectations and then locals returned in size on growing confidence in the political outlook and began to add duration," one local trader said.

Demand at local auctions has been very healthy thanks to the limited supply with new index-linked bonds attracting huge interest. Turkey launched a very well-received inaugural five-year index-linked, lira-denominated bond by auction in February. The new issue is linked to Turkish inflation and offers investors some protection against any repeat of spring 2006's 30% lira slide since currency depreciation feeds through into higher inflation.

The BB/BB– (S&P and Fitch) local currency rated bond attracted a bumper book of TL25bn (US$18bn), enabling the Treasury to raise a bigger-than-expected TL4.1bn from the sale with the 10.0% coupon bond priced at 101.1 to yield 9.72% before rallying on the break. The yield was below expectations thanks to investors' willingness to pay a premium for inflation protection.

S&P noted that the sovereign's first visit to inflation-linked securities since 1999 would "diversify liabilities and, more importantly, the five-year tenor would allow the government to resume its effort to lengthen the maturity structure of its domestic securities".

The average maturity of government securities had been lengthening since 2003, when it was just 18 months, reaching more than 27 months in 2005. After market turbulence that began in May 2006 and the subsequent rise in inflationary pressures and nominal interest rates, this trend flattened, with the average maturity for 2006 at 27.5 months. Also, as inflation fears have receded there is less reason to hedge and this has led to switching out of index-linked paper into straight local T-bills.

Kapax's Pedrajo believes that the big rallies in foreign exchange have largely been played out and that the capital gains will mostly come from bond appreciation on the back of continued rate reductions in more volatile countries like Brazil and Turkey.

Even in investment-grade Mexico, local debt yields are around 7.5%–8% against inflation of 3%, which remains attractive compared to G7 countries, he said. "There is something for everyone in local currency. You might not buy Brazil, but you could buy Mexico where there is still a significant real interest rate," he added.

Still, Russian local markets continue to be boosted by foreign investors' appetite for rouble exposure. Upward pressure on the Russian currency is inevitable given the strength of the economy and massive trade/current account surpluses which have led to huge interest in rouble assets, either through the local bill market or via corporate rouble-denominated bond supply. "In fact, the rouble has become a flight-to-quality play during signs of stress as they are lapped up while the lira and rand, etc, are sold off," said one EM trader.

One area which is seeing huge growth is sub-Saharan Africa where local markets have seen increasing interest from overseas investors.

Nigeria's naira bond market reported a tenfold year-on-year increase in foreign investment in the first half of 2006 – to US$2bn equivalent – according to EMTA. In January 2007, the African Development Bank launched a debut 9.25% N12.78bn (approximately US$100m) one-year bond. This was the first naira-denominated bond issued by a supranational and the largest AFDB issue denominated in an African currency.

In May, West LB priced a Botswana Pula B300m (US$49.5m) 10.4% May 2008 self-led deal that followed two previous deals in the Botswana currency, both for the Triple A rated EIB. The first of those was a similarly sized five-year transaction, followed by a one-year deal that attracted very strong European demand looking to capitalise on the strength of the currency last year in response to economic policy. In June, West LB launched a B310m one-year trade that was issued at par, also with a 10.4% coupon.

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