October 2012

EMERGING MARKET BONDS: Local bonds for local people

SpicesEmerging market bond issuance in local currencies is on the rise. Nicholas Pratt looks at the risks and rewards for international managers and their investors. Emerging market debt issuance in local currencies is on the increase. Over 80% of outstanding bonds are in local currencies and total issuance this year, including hard currency, was $314 billion (€241 billion) to September, according to ING. Issuance is nearly  a third higher than the same period last year. On the sovereign side, the local currency bond market is well developed, highly liquid and responsible for around 90% of all sovereign emerging market debt issuances. “It is a growing asset class and will continue to be the primary way for sovereigns to finance themselves and we are expecting new entries into emerging market local benchmarks in the future,” says Jana Velebova, a member of the emerging market investment team at Rogge Global Partners, an institutional fixed income manager. For sovereigns, the benefits of local currency issues are an improved credit rating through a reduced dependence on external funding and the development of a domestic yield curve, which eliminates currency risk for the sovereign and provides liability-matching assets for local institutional investors. Sovereign issuers have also been able to extend the duration of their locally issued bonds by an average of 18 months, from 3.2 years to 4.7, says John Morton, head of emerging market debt at BNP Paribas Investment Partners. But there are also risks involved for both issuing sovereigns and international investors, says Zsolt Papp, an emerging market fixed income specialist at Union Bancaire Priveé. The issuing sovereign must make sure that the rate and extent of issuance is consistent with the development of the domestic capital market. “A lot of the local currency debt is taken by international investors and if something goes wrong, there could be significant outflows. So there needs to be less reliance on international investors and more reliance on domestic pension funds.” There are also risks for international investors. There is generally a lot more volatility, additional currency risk, liquidity concerns and exposure to the vagaries of local legislation. For example, the tax on all off-shore instruments introduced in Brazil. And the liquidity in local currency issuances can quickly dry up, leaving investors stuck. “It does require a different approach,” says Papp. “A traditional hard currency bond would be managed on a spread basis to give you a good first indication of where it stands in the market, but with an emerging market bond in local currency, there are no benchmarks, as such, so you have to decide where you want to stand on the yield curve of that particular currency.” While the emerging market debt sector has successfully evolved from hard currency sovereign debt to local currency sovereign debt, the same migration in the corporate debt sector has not yet taken place and issuance far outweighs international investor interest at present. For example, roughly 70% – or $2 trillion (€1.5 trillion) – of the $3 trillion emerging market corporate debt market is issued in local currencies yet few international fund managers will include local currency corporate bonds in their emerging market debt funds. “In terms of making that final step to local currency corporate debt, institutional investors would still prefer to see the debt issued in a recognised market, like New York or Luxembourg, where they can be sure of the legal regime,” says Morton. For fund managers, there would have to be an investment in infrastructure and in people in order to establish a fund in local currency emerging market corporate debt. Not only are there indentures from multiple domiciles to review, there are also typically less than 72 hours to price the offering – unlike the many weeks afforded to pricing an initial public offering. “You need a large team to adequately service this market,” says Edwin Gutierrez, portfolio manager at Aberdeen Asset Management. “If you don’t have the manpower to price [a new issuer] in three days, then mistakes can be made.” Consequently, direct due diligence is highly regarded by managers. “The number of issuances we get involved with are a small percentage of the issuances that come to market. It is only after we have gone through the balance sheet and met the management that we will invest.” But managers accept the logic of local currency issuance, especially in terms of the currency mismatch that issuing in hard currency creates. “A lot of these corporates have no business raising dollars because most of their activity is in the local currency. And a lot of these economies – China, Brazil, India – are still relatively closed and the amount of international business is limited,” says Gutierrez. Pioneer Investment has a local currency emerging market fund but it is exclusively sovereign-based at present, says Greg Saichin, head of emerging markets and high yield fixed income. “The corporate market has promise and I have no doubt there will be an index for this, and that the issuing corporates will do so in a more formal framework, but we don’t want to jump the gun and invest in a market where there is no visible benchmark,” he says. Despite the wariness of international institutional investors toward local currency emerging market corporate debt, there is still an enormous need for capital among emerging market corporates and this may present some opportunities for international investors able to exploit this need and able to create advantageous agreements. “The potential yield and the underlying collateralisation could be mutually attractive areas where investors could meet potential issuers, offer high-quality collateral and be given a high net yield to compensate for that, or else look at a one-year rather than five-year duration,” says Morton. “So there are a lot of different things around the coupon or maturity of the bond that could be crafted into the indenture that would make people much more comfortable.” Risk and corporate governance
There may also be investors that are looking for absolute return strategies rather than an index and are, therefore, interested in local currency emerging market corporate debt. And there is merit in these strategies, says Saichin, as long as the risks are well understood. “There is sovereign risk, local duration risk, foreign exchange risk and a range of corporate risks.” So how has corporate governance developed in the developing markets? The large corporates have improved their levels of disclosure, says Saichin, but the mid-market and below continues to have a deficit in the reporting of financial data, governance structure and funding strategies, so you need a skilled analyst to navigate this deficit.” It is also important to recognise that there are different levels of maturity within each emerging market and some, such as South Korea, Singapore, Hong Kong and Taiwan, can barely be considered as emerging, says Velebova. There are also supranational bodies issuing reports that can give guidance on the general quality of corporate governance and transparency levels in specific countries. Meanwhile, says Gutierrez, the increased adoption of international accounting standards is helping managers to compare like with like in their due diligence efforts and alleviates some of the non-transparency issues. Disclosure requirements for local currency issuance may be less stringent than issuance in hard currencies. But, says Saichin, as international investors get more involved in the asset class, the required level of disclosure will become more demanding as will the sophistication of the analysts and this will have a positive effect on corporate governance in local-currency issuing corporates. ©2012 funds europe

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