Monday, 24 September 2018

Local allure

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Enthusiasm for LatAm local currency debt has yet to wane despite heightened volatility in the international markets. It has proven a good bet so far, outperforming most asset classes in the EM universe and acting as a counter-balance to the free falling European and US high yield markets. But with forecasts of a rebound in the US dollar and inflation pressures growing, can the party last? Paul Kilby reports.

A loose US monetary policy combined with a tightening – or neutral – bias in many EM countries mean the carry trade is alive and well. And with more and more money flowing into what is still a nascent asset class, technicals look strong not only for LatAm, but other EM local currency markets.

"You have a decoupling [in local markets] that investors recognise. Emerging economies are not necessarily tied into the subprime mess, though you do have spillover," said one US investor. "There are good performing countries. Colombian pesos, Peruvian soles, Chilean pesos and Asian currencies are all seeing a decent rate of appreciation."

Indeed, local markets have been a good bet in a sea of depressing sell-offs. As of late February, JPMorgan's GBI-EM Global, which tracks local currency EM bonds, saw month-to date and year-to-date returns of 2.35% and 4.03% respectively. That compares to respective returns of -0.27% and 0.41% on the EMBI+, about -1.41% and -3.03% on the Global High Yield Index and -2.35% and -7.82% on Euro High Yield.

"Returns on investment in local fixed-income instruments have greatly exceeded those on sovereign and corporate external credit, reinforcing the secular shift from international to domestic capital markets, especially in terms of exposure to EM sovereigns," said Fitch late last year.

The increasing dominance of local currency instruments can be seen in EMTA's most recent trading figures. Last year, local markets reached their highest annual trading levels since the association started its survey in 1992, with reported activity reaching US$4.264trn last year, a 16% jump on 2007.

Local markets now account for almost two thirds of all EM trading, with the most frequently traded bonds coming from Latin America, namely Mexico and Brazil. Big buyside names such as PIMCO and Ashmore are now just part of the mix of investors piling money into this sector.

Indeed, PIMCO was recently selected from a list of about 35 fund managers to run what is expected to be a US$5bn World Bank fund focused on promoting institutional investments in local currency. This comes as the New York Mercantile Exchange this year established its first futures contracts on LatAm currencies such as the Colombian peso.

Flows into local currency debt markets have far exceeded those in the EM external markets, said JPMorgan in its February survey that tracks buy-side accounts managing money in the emerging markets.

That month local markets saw US$1.7bn and US$0.3bn in strategic and retail flows against just US$0.06bn and US$-0.6bn for the external debt markets. Money indexed against JPMorgan's GBI-EM indices also surged to US$28bn from US$21bn.

"We estimate that inflows into local debt represent 87% of inflows into EM debt thus far this year," the shop said.

If such demand continues, positive technicals are likely to be supportive. Growing international flows into the local currency debt market – plus the approximately US$1.24trn of assets managed by institutional investors in Latin America's principal markets – will likely cause demand to outweigh supply in a regional local market, which, according to Pictet Funds, is valued at just US$250bn.

Many investors still see persuasive reasons for staying in local markets. The region's currencies remain undervalued despite improving fundamentals and burgeoning investment flows, said Pictet, which launched a LatAm local currency debt fund in February. It argued low correlation between LatAm debt and other asset classes gives investors some diversification in this market.

Perceived market decoupling is drawing a number of investors. "Our exposure to local markets has continued to increase," said Alfredo Chang, senior vice-president at Lehman Brothers Asset Management. "When you invest in local markets it helps by generally isolating you to the fundamentals of that country relative to the windstorm happening in the US high-yield markets."

Also as the Fed fights fires in the US with loose monetary policy, the carry trade remains compelling in the local markets. Earlier this year, shops such as Credit Suisse were recommending long exposure to EM local-fixed income markets, particularly those countries that are commodity and energy exporters.

"Given where US rates are, the US dollar has become a new funding currency to other high-yield local markets," Chang added. "The carry argument will increase if [LatAm] central banks tackle monetary pressure. They are on a tightening bias and while the US remains on a loosening bias, that gap will grow."

Dario Pedrajo, senior portfolio manager at Kapax Investment Advisers said: "Domestic markets are more vibrant. Every research house is saying you are better of in the Real than the US dollar. So this year you might see more demand for local issues than US dollars."

With markets increasingly volatile Chang is looking at the more liquid markets, such as the Egyptian pound, which he said is stable, providing a good yield pick-up. There are also some countries that offer short maturities and good opportunities for appreciation, including Colombia and Brazil, which probably offer some of the higher earning currencies, he said.

Others are not entirely convinced. The popularity of local markets has been predicated on steadily declining rates and currencies that have been buoyed by a booming export market, mostly in commodities. If any factors in that equation change, investors may get hurt.

Commodities may take a hit if economic troubles in the US have a broader impact on the global economy. For now, the main focus has been on LatAm inflationary pressures and whether or not central banks will tighten the monetary screws. As one syndicate official said: "Higher rates are good for the currency, but if you own local rates or a fixed-income product you could lose."

Forecasts are also pointing to a bounce in the US dollar, which may take the edge of the carry trades. "Street analysts are arguing that the dollar is going to make a rebound in the second half of the year. So why buy now?" asked David Spegel, global head of EM strategy at ING.

So far the enthusiasm for local currency markets has not spilled into the new issuance market. With many LatAm sovereigns having already established a local currency curve accessible to foreigners, corporates started to tap this market in force in 2007.

Last year saw companies and municipalities raise the equivalent of about US$3.163bn among international investors, with issuers coming from abroad swath of countries including Argentina, Brazil, Colombia, Peru and the Dominican Republic. That is a considerable difference from 2006 when about US$1.214bn of global corporate local currency issues hit the market and they were largely dominated by two big deals from Mexican blue chips America Movil and Telmex.

Unsurprisingly, this year levels have dropped off considerably as market sentiment deteriorated. Not one LatAm corporate has tried its hand at a global local currency deal, though Colombian telecoms operator ETB and BanColombia were both eyeing global peso-denominated bonds before they put their deals on hold this year.

The US dollar remains the currency of choice for EM borrowers, with the dollar accounting for 68% of all placements from EM so far this year, according to ING. In the corporate universe local currency deals represented about 6%, which is in line with the 7% seen in 2007, the shop said.

Despite the recent ardour for all things local and the impressive returns in these markets, investors are still reeling from the subprime fallout in the US and are likely to take a cautious approach.

"Local currency [funds] are receiving cash. Why isn't there greater demand for local currency bond issues? ...It is more a ratings story than a currency story," said Spegel, pointing out that investors have shied away from sub-investment grade and stuck to higher quality credits. "If there were more high-grade local currency issues, you may see more buyers."

While buyers have been attracted to the returns on issues denominated say in Colombian pesos, there are concerns about a weakening in currencies that are hitting new highs. The relative lack of liquidity in such deals has also been a worry in a more risk-averse environment.

In countries like Brazil, the discrepancies between the tighter Global Real curve and the higher-yielding local market make international corporate deals less attractive. "There is an interest but over time investors are getting savvier abut going directly to the local markets," said one syndicate official. "If it is a good corporate in Brazil it could issue 100bp back to the sovereign's Real global, which would be a good cost, but most investors would look at that and say that just gets me flat to the local market."

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