Latin America’s local currency markets are no longer just the preserve of bold investors with a thirst for the exotic. Over the last year, exposure to local risk has become commonplace among emerging market portfolio managers. Across Latin America, sovereigns have been leading their foreign investors from dollar debt to local debt.
“Local markets still offer the best value,” says Joyce Chang, head of emerging markets research at JP Morgan.
According to the IMF, institutional investors might have moved as much as 10% of their emerging market exposure to local currencies globally. Given a dearth in attractive dollar denominated assets, the move makes sense for most major emerging market fixed income investors – the bulk of whom now have significant exposure to local currency debt. Increasingly, the insurance companies and endowments that mandate emerging market investors are asking for up to half of total exposure in local currency.
Stronger fundamentals in emerging markets, the gradual abandonment of rigid exchange rate regimes and the accumulation of large foreign exchange reserves by a growing number of countries have led to a general surge in investor optimism.
“Local currency debt – that’s the new asset class. That’s where the flows will continue to go,” says Anders Faergemann, an emerging markets analyst at AIG. His view gels with the emerging consensus on local debt.
“[Local currency bonds] are here to stay,” says Nicolas Aguzin, chairman for Latin America at JP Morgan. “You have a lot more local investors. They need an instrument in local currency, so this makes perfect sense.”
“I will be shocked if [the trend towards local currency bonds] ends. This really is a fundamental shift,” agrees Michael Schoen, managing director and head of Latin debt capital markets at Credit Suisse in New York.
Brazil
Brazil has been most active in nurturing its local markets. The government has focused on trying to create a fixed rate Real curve, and in adjusting policies to allow foreigners to participate.
In February, the Brazilian treasury exempted foreign investors from the 15% withholding tax on domestic government bonds, opening the doors to what’s likely to be a flood of foreign investment. “We have sorted out the 25-year-old foreign debt problem,” Joaquim Levy, Brazil’s treasury secretary, tells Emerging Markets.
The change could have momentous effects for Brazil’s capital markets, internationalizing the real and helping Brazil build a full scale fixed rate government bond market. The government may also abolish a transactions tax on fund transfers between debt and equity holdings.
“This will be very instrumental in the development of their market. It will extend the duration and allow them to do things Brazil couldn’t before,” says Edwin Gutierrez, emerging markets portfolio manager at Aberdeen Asset Management.
Last September, Brazil broke new ground with its R$3.4 billion reais-denominated, 10-year global bond, led by Goldman Sachs and JP Morgan – the biggest global bond ever issued by an emerging market sovereign in its own currency. It was also the first Latin American local currency bond to offer international investors the prospect of substantial liquidity.
With inflation near 4%, real Brazilian interest rates are well into double digits, the market is a tempting one for most foreign investors. The country’s yield curve is steeply inverted, but even at the long end it yields much more in reais than in dollars. Long-term rates are coming down while the currency is likely to stay strong, if not appreciate further.
“For those of us who have been around for a while, I cannot remember a time when rates have gone down so low,” says the head of debt capital markets at a large international bank.
Yet even these rates are not enough for some investors. “Central bank policy with real interest rates above 10% is excessive. Rates need to come down significantly faster than currently priced in,” says Jerome Booth, head of research at Ashmore Investment Management.
Nevertheless, says Booth: “I’m bullish on Brazil. It’s looking like it will hit investment grade (175bp means only 100bp narrowing to go).”
Mexico
Brazil is following Mexico’s lead in opening its domestic capital markets to
foreign investors. The government’s emphasis on buying back foreign debt means that the local markets will become more important. In Mexico, the yield curve is smooth and liquid all the way out to 20 years, with a 30-year issue expected this year. Corporates price easily off the sovereign, and there’s even a fast-growing market for mortgage-backed securities and other structured products.
The development of the domestic
capital markets has been one of the landmark achievements of Vicente Fox’s government. Mexican pension funds, just like pension funds in Brazil, Chile, Colombia and Peru, are growing at up to 15% a year. The sovereign is now trying to consolidate efforts to develop a full fixed-rate government yield curve in pesos.
“Mexico has done it right,” says Christian Stracke, a senior analyst at CreditSights. But in general he believes that for the market to take off elsewhere, a lot more work needs to be done. “I would certainly stress that transparency of data about debt needs to be improved.”
“It’s still too early to tell whether and which of the domestic local currency markets are here to stay for the international investors.” says Carlos Mauleon, managing director and head of debt capital markets for Latin America at Barclays Capital. “Time will tell, but the trend is positive.”
Chile, meanwhile, has signalled that it is also considering getting rid of the withholding tax of 35% on capital gains on local government bonds for foreign investors. If Chile did eliminate the tax for foreign investors, it would attract more liquidity to the local bond market.
Elsewhere, Peru put its domestic debt market on the international map last year by raising a large part of the $1.5 billion it needed to prepay Paris Club debt in soles. JP Morgan and UBS led the deal, which introduced global investors to the domestic sol market. Colombia also issued the peso equivalent of $325 million of 10-year global peso bonds in February, led by ABN Amro and Citigroup. The sovereign has concentrated on extending the maturity of its local TES government bonds and building a Colombian peso yield curve in the global bond market.
Mauleon believes the best, “lowest-cost” approach is to allow for maximum participation from both foreign and domestic investors. “What sovereigns should do is make the markets accessible to both locals and foreigners alike; Mexico is a good example,” he says.
“Sometimes your local audience will be a better bid than your international audience. Sometimes the reverse will be true, so you should target both audiences.”
“The alternative is to create a global real/peso/sol curve or global local currency curve – but that is not the optimal strategy. Ideally, sovereigns should allow international investors to participate in the local curves. If locals can’t participate in the global curve, you end up with ‘orphan bonds’.”
All told, strengthening the local currency markets is vital for domestic investors. “The locals have been able to improve their ability to fund in local currency, for example the ability to develop derivatives,” says Mauleon.
Caution
The crucial question remains, though, whether the rapidly increasing demand for local currency debt is down to a belief in the improving credit fundamentals of emerging markets, or rather a craving for relatively risky assets as a result of ample global liquidity and a search for yield.
“Investors will have to push the envelope to make yield,” says Gutierrez.
“A shift to less favourable conditions in global fixed income markets could portend a significant exodus by foreigners from local currency markets, if the search for yield turns out to be the driving force behind their entrance into these markets,” is the stark warning in a recent report by the Institute of International Finance.