Currency pioneers

IFR Top 250 Borrowers 2008
10 min read

From Australia to Canada and Ghana to Brazil, the world is home to a plethora of currencies, opening doors to a diverse range of investors and economies. For borrowers willing to put in the extra effort – and take the extra risk – the non core markets offer considerable rewards.

Times are tough for investment bankers of just about every stripe, and it is no different for those in the world of non-core bonds. It is a world that encompasses many markets, many of which have experienced their share of volatility, but there is cause for optimism that what might be called the core of the non-core currencies – Australian, New Zealand and Canadian dollars – could have fully recovered by the end of the year. For the many emerging markets currencies which enjoy considerably less liquidity, the outlook is somewhat more debatable.

Issuance in non-core currencies was again dominated by sovereign, supranational and agency borrowers over the course of the last 12 months, a situation that is set to continue for the foreseeable future. The focus has so far been mainly on the Triple A sector: there is much demand coming from local currency investors and those looking to gain FX exposure. Such investors do not necessarily want to take on undue extra credit exposure through such investments, which is likely to keep interest at the Triple A level.

“International investors will continue to have a strong focus on the SSA sector and banks with a Triple A rating, whereas, when it comes to true local markets, I would expect the role of corporates could increase in the near future,” said Horst Seissinger, head of capital markets at KfW.

The investor base has traditionally comprised principally European and some US institutional investors, but is increasingly being joined by Asians, as well as by retail investors around the world. The growing breadth of investors is making the sector less predictable and more changeable.

US investors have been lured into the sector as a way of diversifying out of the dollar, be it into Turkish lira, Icelandic krona or Australian dollars. In most instances they are looking for high-yielding currencies; many therefore have a reasonable tolerance for the current volatility, and have withstood the volatility that has been ubiquitous throughout the financial markets. In the first quarter of the year the Icelandic krona sold off in one of the most dramatic moves in the non-core sector, but a depreciation of around 30% against the euro only amounted to a decline of about 10% to 15% against the dollar.

Issuers, on the other hand, hope current activity in the non-core markets will prove a precursor to international investors focusing on genuinely domestic credits, which in turn should help develop the local bond market. In the past, once international investors have dipped their toes in non-core waters and got comfortable with the currency exposure they have shown favour to local names relative to internationally recognised ones, preferring local credit risk.

This is to a large extent what has happened in Asia. “The markets are more developed in Asia and the sensitivity of investors towards more complicated types of risk is much more developed than in other parts of the world,” said Seissinger.

For now, local investors are unlikely to eclipse their international peers as the driver for non-core markets, but banks have started to prepare for growth in certain local markets – though there is an expectation this will be confined to certain pockets of activity.

“Over the last two years, there has probably been US$30bn–$35bn a year [of overall non-core issuance], of which last year 55% is going to local markets,” said David Smith, head of CEEMEA local currency new issues business at JP Morgan. Non-core currencies are seeing more investors buy and hold. “There are no real outflows from emerging markets and any little bit of selling is going to be dwarfed by the inflows into the sector,” Smith said.

“Local investors in local markets will look at credit, but they are not going to pay an arbitrage premium,” added Smith. “They will buy General Electric or Rabobank in Czech koruna provided [such deals are] in line with where those credits trade in core markets. If they are going to treat it as a credit diversification, they want to see the full value of the credit as opposed to what has happened historically, where it has been more of an arbitrage vehicle where these issuers are swapping back into dollars or euros.”

An important string to the bow

The non-core markets can be an important source of funding for those issuers that understand its potential. The proportion of KfW’s funding conducted in the non-core markets was around 15% in 2007, the same level as in 2006 – and a similar level to Rabobank’s.

Meanwhile, the EBRD, has been increasing its funding activities in non-core markets such as Romania as it also increasing its lending in such areas. “We are now doing a significant portion of lending in local currency, which I think will only become more important with this crisis going on and concerns about exchange rates,” said Isabelle Laurent, deputy treasurer at the EBRD.

Conditions remain challenging for banks, but some see the opportunity the current credit conditions throw up. “If and when you are long money and want to invest in credit, with good research you can find really nice trades,” said Deutsche Bank’s head of niche currency Eurobonds and corporate credit retail, Holger Kron. “The long funders will make a very nice living this year and the short funders will have a very tough time.”

Even keeping a stable allocation to the non-core markets allows considerable flexibility, as there is such a diverse range of currencies on offer within the sector. “That is also the beauty of being active in these non-core markets, there is always a currency with a good story to tell and where you can do some issuance,” said Sjaak-Jan Baars, responsible for origination and execution of niche currency transactions at Rabobank.

What’s hot? And what’s not?

Currently, some are watching Turkey as a source of some potential opportunity, especially if its correction gets worse, making it look underpriced. Brazil continues to be seen as something of a safe haven, offering a decent yield for a currency that is fundamentally strong.

In terms of growth, some African currencies could also be interesting, starting from very low levels in volume terms, though much depends on the ability of those African countries to develop their capital markets. Even if they perform relatively strongly, in absolute terms it is hard to see them challenging the real or lira markets, being backed by the much bigger Brazilian and Turkish economies respectively.

“The system for making payments is very, very poor,” said Moti Jungreis, managing director of currency trading and fixed income business at TD Securities. Payments of more than US$10m are particularly problematic and some people will be dissuaded by operational risk factors until the continent develops its infrastructure.

Overall, however, emerging markets will be buoyed by their own rising interest rate environments, as their central banks look to control inflation, while the US and Japan keep rates low to stimulate growth. “You have the two-fold aspect of possible interest rate correction – and certainly large differentials – and a currency that is likely to strengthen,” said Laurent. “That is going to underpin these markets very significantly.”

Meanwhile, the experience of those who stayed in the core currencies, and in Triple A securities, but got burned anyway, may convince them a punt on emerging markets doesn’t look so risky after all.

A number of new banks have come to the non-core markets recently, providing the liquidity and credibility capable of attracting new investors. There is concern in some quarters how much commitment new entrants have – an answer to which only time can provide. After all, if market-making can break down in the jumbo Pfandbriefe market – one of the most efficient markets in Europe – it can break down for non-core bonds when times get tough.

Conversely, the banks that have a history in non-core might expect to be rewarded for their commitment. “Sometimes we believe that clients really come back and reward you for liquidity given in bad times, but this is a fairy tale: reality looks different,” said Kron. “In good times you have to fight for the business against broader competition and in bad times you fight for survival in a difficult environment.”

The commitment of investment banks to non-core markets looks assured. “What we saw in the past was cycles in the emerging markets and in the consequent interest of investment banks,” said Seissinger. “Now it is obvious that these markets are in regions of growth where investment banks try to maintain a sustainable interest.”

(This article is based on IFR's Non Core Bond Markets Roundtable.)