Not so long ago, it was difficult to find anyone willing to dip his or her toe in the Latin American local capital markets. Now these markets are seen as the New Frontier for any international investor whose worth is weighed in double-digit returns.
With tight credit spreads worldwide, a weak US dollar and an external emerging debt market expected to return minus 3% (when the negative return on US Treasuries is taken into account), investors have begun to make strategic allocations in local emerging currency debt.
This year's rise in US Treasury yields has caused an unwinding of shorter-term tactical trades in Mexico and Brazil, raising the red flag that the local market investment trend was a flash in the pan.
Proponents of the new asset class argue, however, that the logic behind a strategic investment in local currency debt still stands.
For one, the global quest for yield will continue. US Treasury yields may be on the rise, but they aren't likely to return to the heady levels of the 1980s and early 1990s.
"This is not about fashion," says Jerome Booth, head of research at Ashmore Investments in London. "It's about major shortfalls since 2000 in people's institutional bond portfolios, and their realization that they have to stop investing in their own domestic bond markets. Investing only in hard currency debt just won't cut it any more in a world where government bond yields are expected to remain historically low."
In any case, the structural reforms that have taken place in Latin America over the past few years mean that the region is now a sound investment.
"The convergence to orthodox fiscal and monetary policies and the marked improvement in external accounts have underpinned what I see as a structural change in Latin economies and, as such, one that is unlikely to revert," says Drausio Giacomelli, head of JP Morgan's Latin American local credit market strategy group.
Giacomelli argues the local markets are worthy of more than just short-term tactical "hot money" carry trades; they should now be awarded a strategic allocation in dedicated emerging market external debt portfolios and even general global debt funds, because of their diversification benefits.
"One of the most important recent developments in Latin local markets is the increasing decoupling between local and external [emerging market debt] yields" because of the structural and fiscal reforms, says Giacomelli.
Now that much of the region has floating currencies absorbing external shocks, more open trade regulations, current account surpluses and declining external short-term indebtedness, local yields react more to domestic factors like inflation and monetary policy, than external events.
"There are lower correlations between external emerging market debt spreads and local currencies," says Giacomelli, "and that means the local markets have become an interesting diversification alternative for foreign investors."
Booth argues that local currency emerging debt is not only higher yielding but is also less volatile than many developed market products, such as US Treasuries.
"What is going on is that institutional investors are realizing that local currency emerging debt is a good diversifier with a high yield," says Booth. "As such, local emerging currency debt as an asset class should be viewed as something investors need to have a certain allocation to in their portfolio on a permanent basis, and not as something that's hot this month and not the next."
Although the convergence play in the local Mexican debt and foreign exchange market has been evident since the late 1990s, it only really gained force last year, when the Mexican peso appreciated sharply against a weakening US dollar.
Mexican triple
For a local market to attract foreign investors' interest, a country needs at least two out of three pillars: fiscal and monetary discipline, a thriving local institutional investor base, and convergence of local inflation and yields to developed country levels.
Mexico is the only country in the region sporting all three, and is also the only Latin country with no foreign investment entry barriers in its capital markets.
In the last six years, assets under management in Mexico's pension fund system has grown to more than $44 billion, letting the government extend its yield curve from one year Cetes to 20-year fixed rate Bonos.
Corporate issuance volume has boomed, from virtually nothing in 1999 to about $6 billion last year, including a $450 million mortgage-backed securities market.
The government and blue-chip issuers like Pemex can now raise at least half of their yearly funding requirements at home in their own currency, further improving Mexico's fundamentals by reducing its dependence on external debt.
There are other advanced local bond markets in the region, but for the most part they are either too small as in Peru, their local yields are too low, for example Chile, or have too many barriers of entry to invest in directly – Colombia and Brazil.
Colombia has a private pension fund system and a local peso curve out to 10 years, but capital movement restrictions discourage foreign investment in the local market. Foreign investors instead have gained exposure by buying the sovereign's recent peso-denominated global bonds.
Argentina has a developed local market, a private pension system and the most obviously under-valued currency in the region. Foreign investors have set up positions to benefit from peso appreciation by buying peso-denominated 30-year bonds in the country's recent debt exchange. For the moment, however, local liquidity in peso bonds is limited by the fact that pension funds, which already hold about 70% of their assets in government securities, aren't keen to buy much more.
One of the biggest attractions in Latin America is Brazil's local market. Brazil has neither a privatized pension system, nor a fixed-rate government bond curve beyond a year in maturity. But what it does have is a transformed economy.
Brazil has gone from a primary public-sector deficit of 1% of GDP in the late 1990s to a 4.6% primary surplus in 2005. Likewise, the current account has improved from a 4% deficit in 1999 to a 2% surplus. More importantly, Brazil has extraordinarily high local nominal interest rates as a result of the central bank's inflation targeting policy.
"That's the big one that's attracting a lot of interest," says Giacomelli. "Brazil is today where Mexico was in 1999. You have inflation of 5% and rates of 19.25%, so there is a very high probability that one year from now Brazilian domestic rates will be much lower."
Various portfolio models given as examples by banks like JP Morgan back arguments that by adding exposure to Mexican and Brazilian local markets, a global bond investor can boost Sharpe ratios (a measurement of risk-reward).
Frontier dangers
But that's not to say the local markets are without risks; as with any new frontier, the pitfalls are often only discovered after one blunders. In Mexico, for instance, no one ever expected the local pension fund investors to run away at the first sign of rising US rates.
"The local pension funds have sold out of the long end of the peso curve and are buying short-dated bonds and bills," says Igor Arsenin, local market strategist at CSFB. "It's been a big disappointment for the rest of the market because, theoretically, the pension funds should have a longer investment horizon and should be the most reliable demand for the long-term Mexican Bonos."
The Mexican pension fund institutional investor base is only about six years old and has never lived through a cycle of increasing interest rates. With 2006 election noise already gaining volume and US Treasury yields on the rise, pension funds have crawled into their shells and put their money in the short end of the peso curve. "People have given up hope any time soon that they will provide a bid to the market," said a local banker.
That's left foreign investors sitting on a mountain of long-dated Mexican peso bonds and little in the way of a natural local bid from the pension funds.
"Foreigners practically own the long end of the Bono curve, and everyone is concerned about at what point they will pull out their positions," the local banker added. "The reality is, when risk appetite reduces [because of rising US Treasury yields], people don't want to increase their exposure in markets away from their benchmarks."
Foreign investors weren't adding positions at the long end of the Mexican curve, as demonstrated by the poor turnout for Mexico's 20-year Bonos auction in mid March.
The next big tactical trade in Mexico will be if and when its central bank drops its monetary policy of accommodating US Fed moves on rates. Tightening rates is fine for a country where real rates are close to zero, as in the US, but not for Mexico, whose real rates are about 4.5%. The bet is that Mexico's central bank will instead adopt a new monetary policy that targets inflation, a move that should spark a rally in the peso.
As for the longer end of Mexico's peso curve, it will turn out to be a much better returning investment in the longer term, argues Arsenin."I don't think having a position in 10- and 20-year Bonos is bad," he says. "In a year or two I think this trade will work and investors will have better returns than if they stayed in Mexican hard currency bonds. "
The local-global trade
Latin American borrowers are issuing local currency global bonds to attract international investment
With so many restrictions on foreign investment in most local Latin American markets, borrowers have had to find alternative ways of capturing the wave of international interest in local currency debt.
Banks such as Citigroup and ABN Amro have been at the forefront of developing the concept of bringing the sovereign and its local currency debt to the global investor rather than making the latter tackle a jungle of regulations to invest directly in the domestic markets.
In October 2003, Citigroup structured and underwrote the first global bond of any kind in a Latin American currency, Uruguay's $200 million three-year global bond indexed to inflation.
The deal, the grand finale of Uruguay's $5.2 billion voluntary debt restructuring in May 2003, allowed a country with little liquidity in its capital markets to raise a significant sum in its own currency.
The Latin nation followed it up nine months later with a $250 million equivalent two-year global devaluation protection note, led by ABN and Citigroup.
Its success set the stage for Colombia's ground-breaking $375 million equivalent five-year peso-denominated global bond in November. This was the first vanilla global issue in a Latin currency and one which saw sole bookrunner Citigroup bombarded with more than $1.1 billion in orders (see page xx for "Deals of the Year").
The fact that it was one of the rare chances to buy a Colombian peso bond was enough to overcome concerns about the government's decision to cap the peso's appreciation.
Investor interest was further whipped up by rumours that Brazil was coming with a similarly structured global bond denominated in reais. When that didn't materialize, Brazilian banks quickly stepped in, as well as the IDB, and issued a flurry of small reais-denominated eurobonds, with tenors ranging from18 months to five years.
The issuance continued in the first months of this year. Colombia returned with a $325 million-equivalent 10-year peso global bond, led by ABN Amro.
In the same week Brazilian banks Banco ABN Amro Real, Banco Votorantim, the European Investment Bank and the World Bank priced reais-denominated eurobonds.
The investor base expanded with every Brazilian bank deal. "The guys you now see in these deals are no longer just Brazilian high-net worth accounts," says Nick Darrant, a syndicate official at ABN Amro in London. "Now it's dedicated investors, hedge funds, insurance companies and pension funds coming in to pick up double digit yields." Those deals sold for nominal yields in the 16.25% range.
Whether the Latin currency eurobond/global bond trend continues in a US rate rising environment remains to be seen.
One of the hottest plays in the international capital markets is Brazil, with real interest rates, presently at 14.15%, widely expected to come down as the country's central bank meets its 5.1% inflation target.
Brazil's barriers are so high that foreign investment in its local debt market is close to zero.
Not to be discouraged by the small print, banks have instead offered investors an array of derivative products that give them exposure to the local currency and interest rates. The most favoured way to get exposure is through the NDF (non-deliverable forwards) market.
NDFs settle in US dollars without any principal exchange involved. Investors receive the difference between the initial forward rate and the BRL/USD spot rate on the day the contract settles, say in a month.
They offer good liquidity up to one year, and typical tickets are $2 million-$5 million. Transactions of up to $25 million can be done without significantly impacting prices.
Banks reap rewards of corporate boom
The growth of corporate bond market in Latin America has taken off in the last five years, and both the local and the international banks in the region are reaping the benefits.
In the past six years, Mexico's corporate bond market has grown in volume to around $6 billion including a mortgage-backed securities market, and tenors have extended out to 10 years.
With local pension funds eager to diversify their holdings of mainly government debt, issuers like Pemex are able to raise $3 billion in one year with ease. In February, Pemex raised Ps15 billion ($1.3 billion) in the local bond market, a deal that extended its peso fixed-rate yield curve out to eight years, attracted more than Ps40 billion in orders and priced tighter than its initial guidance.
And it's the international banks that are raking in the fees. Citigroup, Banco BBVA and Santander respectively own Mexico's three biggest banks: Banamex, Bancomer and Serfin. Other international players that have turned up with peso securitization mandates include CSFB and UBS. One of the few banks winning corporate local peso bond mandates is Banco Inbursa.
In Brazil, international banks such as CSFB, JP Morgan and Citigroup are well entrenched in the local capital markets. Yet with perhaps the exception of ABN Amro, which now owns Banco Real, and the local Brazilian branch of Santander, it's usually local banks like Banco Itau BBA, Pactual, Bradesco, Unibanco and BB Investimentos that turn up with corporate debenture mandates.
Local bankers expect volume for plain vanilla debenture deals to comfortably exceed R$15 billion ($5.6 billion) this year.
In January almost R$5 billion of corporate debentures was priced. In March many corporates were holding back deals in anticipation of local yields falling.
Average deal size has started to increase in the Brazilian corporate market, with deals around R$300 million in size from an average R$150 million-R$200 million at the end of last year.
Pricing has also become more aggressive, and fees have also started to drop as banks like Banco Itau BBA cut fees in a bid to win market share.
A local securitization market has also started to blossom in Brazil through the use of the so-called FIDC funds, which provide, among other things, the ability for more leveraged companies to access the local markets.