A history of inflation is one underlying reason why the Chilean fixed income market is so complex today, writes Lorenzo Naranjo, of the ESSEC Business School.
The Chilean fixed income market is complex mainly for historical reasons. The first idiosyncrasy is the large number of inflation-protected bonds outstanding.
Though this pattern has changed over the past ten years and more debt is denominated in Chilean pesos, inflation-protected securities still represent a large share of the total amount.
After the high inflation periods of the 1970s and early 1980s, almost all government debt, mortgages and corporate bonds were denominated in the Unidad de Fomento (UF) rather than in Chilean pesos. The UF is an official unit of account that adjusts every month with the consumer price index.
Until 2001, the overnight reference rate set up by the central bank was also denominated in UF. The central bank has recently decided to conduct its monetary policy in nominal terms, which is the standard way of doing it in many developed economies.
A second peculiarity is that much secondary market trading is done at the Santiago Stock Exchange. Even though there is an active over-the-counter (OTC) market for bonds, pension funds are required by law to trade at the local exchange so that all purchases and sales are done at transparent prices.
Pension funds represent a large share of the market compared with other countries. By law the retirement savings of all Chileans are held at these institutions.
A third peculiarity of the debt market is that benchmark government bonds, both real and nominal, are not only issued by the Chilean government but also by the central bank, in many cases with more liquidity, making them “official” benchmarks. These bonds give the central bank a useful tool to conduct its monetary policy, since it can inject or drain liquidity without affecting the indebtedness of the government.
Real and nominal benchmark bonds in Chile are issued by the central bank and the Ministry of Finance. In the case of the central bank, inflation-protected bonds used to be issued as zero-coupon bonds for short maturities and as amortising bonds for maturities of eight and 20 years. A coupon-stripping programme allowed zero-coupon bonds to be traded.
After 2002, the central bank decided to start issuing bonds that were similar to the ones existing in other countries, discontinuing the emission of amortising bonds. Inflation-protected bonds issued by the central bank today are bullet-type bonds with maturities ranging from five to 20 years. On the other hand, the Chilean government also issues inflation-protected bonds with maturities ranging from five to 30 years.
At the same time, the central bank started issuing bullet-type bonds denominated in Chilean pesos with maturities ranging from two to ten years. Before this, only short-term zero-coupon bonds were denominated in Chilean pesos.
The Ministry of Finance also issues bonds in domestic currency with maturities ranging from five to 20 years.
In the past, the central bank also issued US dollar-denominated bonds, which were useful for managing the foreign reserves when the exchange rate was not allowed to float freely.
These have since disappeared.
As of June 2011, 47% of the central bank’s debt was inflation-protected debt, whereas 53% was denominated in domestic currency.
Furthermore, having real and nominal securities is useful because they provide market-based forecasts of future inflation. For example, Figure 1 plots the yield-to-maturity of real (BCU) and nominal (BCP) five-year bonds from September 2011 to September 2012. During the period, the implicit five-year annualised inflation has been around 3%.
Since benchmark bonds are among the most liquid fixed-income instruments in Chile, all market participants take part in their trading: banks, pension funds, mutual funds, insurance companies and brokers. As with all bonds in Chile, benchmark bonds are traded OTC and in the local stock exchange. For government bonds, the OTC market represents the largest share in terms of traded volume (64%) when compared with the total amount traded at the local stock exchange (36%).
Within the OTC market, 92% of the traded volume is done by banks in the so-called interbank market. This market is liquid, with bid-ask spreads of around two to three basis points for on-the-run bonds. Within the local stock exchange, most of the trading (87%) is done through several call-auctions held during the day, whereas the rest of the trading is done through a continuous-type auction system (Telerenta).
The Ministry of Finance also issues abroad sovereign bonds denominated in US dollars and Chilean pesos. These issues have been in high demand among foreign investors, mainly because the credit quality of the Chilean government (Aa3, A+) is perceived to be good. Credit default swaps contracts are also available to insure the bonds.
MORTGAGES AND CORPORATES
Mortgages in Chile are also traded either OTC or in the local exchange in the form of mortgage bonds and mortgage-backed securities. For historical reasons, most of the mortgage securities are inflation-protected, paying a fixed-rate with a prepayment option for the borrower, although now some securities are denominated in Chilean pesos. Corporate bonds in the local market are issued in UF, Chilean pesos and sometimes in dollars. Some of the largest Chilean companies have also issued corporate bonds abroad.
A large proportion of mortgage-type securities and corporate bonds are usually held until maturity by insurance companies and pension funds, making their liquidity small. Even though every day there are transactions for some of these securities, it is not common for them to trade very frequently. The illiquidity of these bonds poses several challenges for the pricing and risk-management of portfolios of these securities.
Lorenzo Naranjo is a professor in the finance department at ESSEC Business School
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