San Miguel Brewery, the Philippine beer maker, astonished investors in March when it issued 38.8 billion pesos ($800 million) of debt in its local bond market.
The deal was remarkable not only for being the largest peso-denominated issue on record; it also showed that local debt markets were more resistant to the global crisis than many people had feared. The crisis has put emerging markets through a rigorous test, which they have passed, says Agnes Belaisch, emerging markets strategist at Threadneedle, the investment manager. Local debt is looking increasingly attractive to investors.
Local currency bonds account for more than two-thirds (69%) of all debt issuance from developing countries so far this year, as governments pay down external debt and issue more cheaply in their local markets. As recently as 2004, the instruments accounted for less than half (46%) of the total, according to data providers Dealogic.
Debt to GDP ratios in advanced countries are more than 100%, according to Threadneedle. In contrast, in emerging economies the ratio is less than 50%, making local institutions a better source of finance than foreign lenders.
Since April, local currency bond funds have attracted $1.4 billion in new money from investors, according to Boston-based fund tracker EPFR Global. Compared to emerging market equity funds (which attracted $33.8 billion over the same period), local currency debt remains peripheral for many foreign investors. But one investor described the instruments as a new and increasingly significant asset class.
The reasons why
The main arguments for investing in local currency bonds are two-fold. First, many believe developing market currencies will strengthen on the basis of improving fundamentals against a weakening US dollar. Nine years ago only a third of developing countries were rated investment grade; today more than half of them enjoy that rating. Second, there is the opportunity for sky-high spreads, which economists say over-compensate investors for the risks of investing in relatively stable economies, amid falling interest rates and inflation. Investment consultants also view local debt as a way of reducing risk, if the rest of a portfolio is invested in more mainstream assets.
Hungarian spreads touched nearly 1,000 basis points (bps) earlier this year and are now back below 500bps. This kind of rally would have provided a huge return for Hungarian forint bond investors, way beyond anything from developed markets. There has been even more spectacular performance from the Turkish and Brazilian markets, says Nigel Rendell, emerging market strategist at RBC Capital Markets.
Longer-dated maturities, around 10 years, offer good value to investors, according to Rendell. At September 3, 10-year Czech local currency government debt was yielding 5.1%, 183bps more than on equivalent German bonds. Yields for Hungarian forint debt were even higher, at 8.2%, while Polish zloty paper was yielding 6.1% and Slovakian koruna 4.8%. Despite such high spreads, default looks unlikely, particularly in light of the IMFs new lending programmes, including its flexible credit line, introduced in March.
Yields on Latin American local bonds were even higher than in eastern Europe. Brazilian five-year local government bonds were yielding 12.3% (at September 3), Mexican bonds 7.4% and Turkish lire paper 11.6%, according to RBC Capital Markets. In contrast, US bonds were offering just 2.3%, showing the upside potential on local emerging markets bonds.
Jerome Booth, head of research at Ashmore Investment Management, believes emerging markets currencies are set to appreciate by as much as a third against the US dollar and says he views local debt as an insurance policy against dollar weakness. Ashmore has around a fifth of its $25 billion emerging market assets in local bonds. He says: When we talk about the risk-free rate in US Treasuries, thats an abuse of the English language. Its not true at all. The US dollar is one of the riskiest currencies there is. The risk of a sudden reversal in the US dollar is greater than in a basket of emerging markets currencies. The issue in the global economy today is how to manage the dollar down slowly without a crash.
Local currency bonds can represent the best route to gain exposure to individual countries. RBC Capital Markets Rendell says: Local currency debt is a purer play on the country than either equities or external debt. [It] gives you direct exposure to how individual countries are performing, more so than external debt. Equities are more dependent on how the corporate in question is performing than on the country itself. If you want exposure to a countrys fundamentals the local currency debt market is the best way to do that. Outstanding volumes of Brady bonds are declining and Eurobonds can be in short supply, adds Rendell.
Leading UK pension fund consultancy Watson Wyatt is recommending that clients interested in emerging market debt invest in local currency bonds. If clients want to invest in emerging market debt, local currency is an appealing route to pursue. These markets are deeper and more liquid than the external debt markets, says Mark Horne, the firms senior investment consultant.
Emerging market governments rely most heavily on their home markets for funding; sovereign local bonds account for around 57% of outstanding emerging market debt [see table, p. 29]. The figure for hard currency government debt is just 6%.
However, the leading index for tracking debt issued by emerging markets in local currencies (the JP Morgan GBI-EM) has not done as well as its hard currency equivalent in recent months. The local currency JP Morgan GBI-EM managed only a 14.3% increase to September 4 year to date, compared to a 22.3% rise in the hard currency EMBI index.
Some local currency bond funds have lagged the broader universe of emerging market debt funds so far this year. The overall US open-ended emerging market bond fund universe tracked by fund analysts Morningstar was up 23% year to date at September 2. However, the Pimco Developing Local Markets Fund, set up in 2005 to target local currency bonds, returned 15% and the Pimco Emerging Local Bond Fund 19%.
The Dreyfus Emerging Markets Debt Local Currency Fund, launched in September last year, also trails the broader universe. The fund was up 13.3% to September 2, compared to the 23% average.
The £28.6 million Threadneedle Emerging Market Local Fund, launched in January 2008 to invest in domestic debt, lost 3% of its value in the first half of this year. In contrast, the Threadneedle Emerging Market Bond Fund, with more than 90% of its £419 million assets invested in hard currency instruments, and run by the same manager, was up 3% over the same six months.
Hard currency emerging market debt funds do seem to have done a little bit better [than local currency versions] and its possible there is still a certain amount of risk aversion to [stand-alone local currency], says Morningstar senior mutual fund analyst Lawrence Jones. Investors are willing to go into emerging market debt, but theres still unwillingness to take currency risk in those instruments given uncertainty over US dollar direction, at least in the short to medium term.
Jason Hepner, investment director for global strategy at Standard Life Investments, is among those sceptical about the appeal of local currency bonds. Our view is that a lot of the good news is already in the price for emerging market assets, at least in the short term, he says.
The Brazilian real has risen 24% against the US dollar so far this year (to September 3), Hepner points out. A 15% rise in the Chilean peso and 23% hike in South African rand also suggest less potential for currency appreciation, one of the biggest arguments for investing in local currency bonds. Hepner says: Because emerging market risk appears to have run a long way and done so well year to date, I would be cautious about adding at this stage. The price may well have run ahead of fundamentals.
Local currency bonds with short maturities (between two and five years) no longer present as many opportunities as they did earlier this year, when rates were tumbling, cautions RBC Capital Markets Rendell. In most countries local rates are down as far as they will go, with a few exceptions. Latin America, for example, has done most of the work on rates, he says.
Trading of local currency bonds is shrinking. Turnover in the instruments fell back by more than a quarter in the second three months of this year to $600 billion, compared with a year previously (data from EMTA, the association for emerging markets traders). Turnover was also down (by 8%) on the first quarter. In contrast, Eurobond trading rose 48% in the second quarter to $374 billion, from the first three months of the year, suggesting an investor preference for hard currency instruments.
Local bonds are falling as a percentage of total emerging market debt traded; in the second three months of this year they accounted for 61% of total turnover, according to EMTA, down from their 72% share in the first quarter and also from the 68% they held for the five previous quarters.
Evidence suggests that, for a while at least, investors remain cautious on domestic paper. However, as the San Miguel deal shows, there are still opportunities. Many investors may yet be prepared to toast the prospects for local bond markets.
HOW TO INVEST IN LOCAL DEBT
Watson Wyatt, the leading investment consultancy, is advising its clients, who include leading UK pension funds, to allocate between 2% and 3% of their portfolios to emerging market debt. Not a significant amount, but meaningful, says Mark Horne, senior investment consultant at the firm. Watson Wyatt suggests around half the investment goes into local currency bonds. Pre-crisis we were suggesting that the entire allocation be local; now we are advising a 50/50 blend [of hard and local currency debt].
There is an increasing choice of investment routes. Fund flow tracker EPFR Global monitors 84 dedicated emerging markets local currency bond funds, with $16.9 billion in assets. The firm follows a further 44 funds with $11.3 billion in assets that are a blend of hard and local currency instruments. It also tracks 131 hard currency bond funds with $39.7 billion in assets.
In June 2006 Pictet launched the $447 million PF (Lux) Emerging Local Currency Debt Fund. More and more we see [local currency debt] starting to figure as a separate line, says Simon Lue-Fong, the funds manager. The base scenario for us is that [local currency] will become more mainstream, especially among institutional investors looking for coupon-paying instruments that can be used for liability matching and that are uncorrelated to other assets they hold. Threadneedle, Dreyfus and Pimco are also among those firms to have launched local currency debt funds in recent years.
Watson Wyatts Horne advises investors to opt for funds that invest in both local and hard currency: We think a blended approach is prudent and seek out skilled managers who can invest across external and local currency debt.
Lawrence Jones, mutual fund analyst at Morningstar, says: You will find a lot of the emerging markets hard currency funds will have a stake in local currency bonds, typically between 7% and 20%, depending on how the manager is feeling about the dollar valuation to these currencies. H.F.