The choice of sovereign paper available to emerging market debt investors is getting larger. Starting with issues such as the Lebanon global bond issued two years ago, countries such as Estonia, Kazakhstan, Moldavia and Oman have issued debt on the international markets for the first time. And a debut £50 million floating-rate note issue is expected in the first half of this year from Sri Lanka.
Although the large-scale emerging market issues in the last few years have come from Mexico and Argentina and have continued so far this year with large issues from both countries in January new sovereign issuers have started a trend for accessing international capital markets. Some emerging market countries are engaged in a process of debt restructuring; two recent bond issues that fall into this category are those from Croatia and Panama issued on the Euromarkets in early February. Others are governments that have not been in a position to issue debt in such a way before.
“In the current environment the market is very receptive to new names with improving credit ratings and well-marketed stories,” says Richard Luddington, head of emerging market debt syndicate at JP Morgan in London. Pressures on cross-over institutional buyers to increase yields, spread risk and diversify portfolios are always strong. But fund managers have been eager to look farther afield since the Mexican peso crisis burnt their fingers in 1994. Latin America was and is a major source of both Brady bond and Eurobond supply and has attracted disproportionate amounts of investment capital. Following the Mexican crisis there was a sharpened awareness on the part of global funds of the need to diversify. As a result, an increased weighting has been given to other emerging regions such as Asia and Eastern Europe at the expense of Latin America.
The present receptivity of the global bond markets to emerging market debt is borne out by the figures. Total emerging market sovereign debt in 1996 was, at US$88 billion, roughly twice the level of 1997. US treasuries returned around 3% last year at the same time as JP Morgan’s Emerging Market Bond Index returned around 39%. Even with the possibility of a rise in US treasury yields this year following on from higher US interest rates, the returns from the emerging market debt newcomers will still be comfortably higher. Returns from newcomers to the global bond markets such as Algerian paper have been in double figures in the fourth quarter of 1996.
But positive economic news leading to new credit ratings or upgrading of existing ratings is the other half of the equation. Croatia, the Czech Republic, Kazakhstan, Poland, Russia, Slovakia and Slovenia have all received ratings from the major credit ratings agencies for the first time since the Mexican crash. All those countries have either issued or are expected to issue sovereign bonds for the first time. Market participants are predicting new issues later in the year from CIS (Commonwealth of Independent States) countries such as Ukraine and Uzbekistan, taking advantage of new credit ratings and a new ability to access international markets.
Added to this are two other factors: the difficulty in gaining exposure to domestic bond markets has made non-domestic debt issues particularly Eurobonds all the more likely. There is also the potential for reduced Brady bond supply as long-term emerging market debt issuers most prominently Mexico and Argentina concentrate on liability management. Mexico’s Brady buy-back in 1996 has led to a feeling that Brady supply may shrink.
The imminent European single currency is also having an indirect effect on emerging market bonds. Many participants in the emerging market debt arena on both the buy and sell sides are planning with the euro in mind. Borrowing in Deutschmarks, for instance, must take into account eventual redenomination in euros. But there is evidence that bond investors are already looking to increase on future yields in their euro portfolios by looking to some of the stronger and better developed domestic emerging market bond markets.
The domestic Czech bond market is denominated in the Czech currency, the koruna, which is pegged both to the Deutschmark and dollar. Already it offers healthy yields that look set to continue that way for the near future. Similarly, the recent upturn in issues in the Euro-Czech koruna market shows that interest is building among investors in high-yielding proxies for the Deutschmark.
The advent of the euro is already being priced into certain emerging market bonds. But such arbitrage does not last long in the bond markets, says JP Morgan’s Luddington. “Lengthening maturities in domestic emerging market issues and deepening investor interest in those markets is one of the main trends in emerging markets. The sophistication of the global investor base has grown. Trends in the Euro markets and global markets are being played out already. Spreads have tightened as attention is focused on local markets,” he says.
But institutional investors will be careful to look only to the more developed emerging markets to gain this sort of exposure. The recent crises in Albania and Bulgaria show that, in eastern Europe at least, traditional investment-grade buyers that are beginning to look further down the credit curve to the likes of the domestic Czech market to beat their indices should beware. Such institutional buyers have different views to specialist emerging market investors who may begin to think that some emerging markets are becoming too expensive. “People should be looking on a country-by-country basis,” says Luddington, “because the problems that occasionally happen are country-specific. It shows that emerging market debt does not go in a straight line.”
Does the rise of new LDC (less developed country) debt therefore mean that market participants are coming back to the idea that “sovereigns don’t go bust”, (the infamous comment by Walter Wriston, chairman of Citibank, just before the bank’s debt book began to turn red)? No, says Abdullah Nauphal, global fixed-income strategist at Schroder Capital Management International in New York but liquidity might become a problem in certain circumstances. Although liquidity is presently high among emerging market debt with fund managers under pressure to diversify, any shocks, like the Mexican crash or a developed-world downturn might force nervous institutional money out of the markets. “I personally don’t like a lot of these new issues,” says Nauphal. “If developed countries’ interest rates rise, which they may do, the door to get out of this new emerging market debt becomes very narrow.”
Club Med debt
The last two years have been years of convergence in European bond markets with spreads on Italian, Spanish and Portuguese sovereign bonds so-called Club Med debt approaching those of northern European countries that look set to join the first wave of economic and monetary union (Emu) in 1999. But this year the situation may have started to reverse. As doubts have grown about the likelihood of all Maastricht signatories meeting the criteria for monetary union, the market may have begun pricing Club Med paper accordingly.
This process has been happening for some time. Yields and coupon rates for Club Med paper followed the market wisdom that Emu-inspired monetary, fiscal and political discipline would force second-tier European countries into financial rectitude. Yields on Italian, Portuguese and Spanish paper converged with those of the bonds denominated in core currencies particularly the Deutschmark. The spread on 10-year Italian government bonds as against 10-year German government bonds is around 160 basis points, compared with 500bp two years ago. Spanish debt has undergone a similar fall to stand at a spread of around 160bp at present. And, significantly, yield spreads on southern European debt have been closer to those of benchmark Deutschmark bonds than those of UK gilts.
But there is some evidence to show that spreads between core-currency debt and Club Med debt will widen throughout the year. “There are obvious pressures on the buy side to hold either core countries’ debt or those countries which were not going to take part in Emu in any case,” says Julian Jessop, chief European economist at Nikko Europe. “The markets to avoid may be those that benefited by the convergence that has been seen in 1996.”
Jessop is firm on this point. “It’s difficult to argue for buying them at current levels when there is so much convergence already priced in,” he concludes. But, ironically, countries like Italy and Spain have made improvements in economic fundamentals so are simultaneously seen by some bond experts as good long-term holds.
Gerhardt Abel, head of European bond origination for Dresdner Kleinwort Benson, does not believe that spreads will begin to widen significantly. Improved economic performance and a show of political determination amongst the countries concerned will, Abel believes, keep bond investors of one mind. “From a European political perspective, even if they do not join in the first wave, there is a lot of pressure for them to join very soon. They have a commitment to be in, and they want to be in,” he says. “I don’t believe there will be a significant spread widening given the economic stability and improvement on budget discipline that we have seen. There’s no evidence for it.”
One thing is certain: at the moment the three blocs of bond trading in Europe appear to correspond to positions on the single currency. Even with tightening spreads the core countries of Belgium, France, Germany and the Netherlands, which are most likely to join the first wave, are trading at different levels to weaker candidates for Emu such as Italy, Portugal and Spain. The third group consists of the “safe havens” countries like the UK and Denmark which look bad bets for entering monetary union in the first round but have strong and stable markets in their debt.
This is emphasized by market participants who believe there is a real risk that even Germany and France may miss the economic targets set down for monetary union. “Increasingly markets like the UK and Denmark are going to be seen as safe havens,” says Nikko Europe’s Jessop. “They have good economic fundamentals, whether they join economic union or not, or whether economic union takes place at all.”
But the safe-haven theory is not held by all market participants. Dresdner Kleinwort Benson’s Abel believes that markets likely to be left out of Emu will only be seen as safe havens when a safe haven is needed, and that time is not here yet. “For the time being the feeling is quite positive towards Emu. But if it looks as though Emu is being destabilized or is causing problems, then the safe-haven theory comes into play,” he says. “But yields on European sovereign debt should really be the other way round. UK yields should not be so high compared to other European countries.”
But it is not hard to see why they are. “There is an embedded free option in UK gilts and Danish government bonds,” says Mark Fox, chief European strategist for Lehman Brothers. “If and when sterling and the Danish krone do join, spreads will converge with core debt. But if there is a problem, that’s when they become attractive.”
Supranational debt
In a response to the same economic pressures, the imminent arrival of the euro has, in the first quarter of this year, begun concentrating the minds of supranational debt issuers in the European markets. The European Investment Bank (EIB), in particular, is raising money with one eye on 1999 the proposed start date of the European single currency. The recent euro 1 billion bond, temporarily denominated in Ecu, and a recent fls1 billion bond are the first to explicitly design in the imminent euro with a new type of “further issue” structure.
As with all outstanding debt, the EIB bonds will be redenominated in euros in 1999. But there is a deeper change in the EIB’s recent borrowing. At the advent of the euro, all subsequent EIB debt instruments can merge into one interchangeable euro issue because of changes to the usual further-issue clauses they carry.
The new clause allows for complete fungibility between them and subsequent issues, of whatever currency, at the start of the single currency. Bond issues up to the EIB issue contain legal mechanisms which allow for further issues but in the same currency. The recent so-called “host” issues from the EIB will allow for further issues denominated in different currencies to feed into one very liquid market: they will be “tributary issues”, in the language of the EIB.
It is this aspect that has potentially large implications for European markets and not their one-to-one fungibility with each other, nor the recent euro issue from the EIB, nor their certain conversion into actual euros in 1999. Faced with the choice of buying securities that will only be exchangeable with other securities denominated in the same currency, or debt that will be exchangeable with any other currency with the same further-issue clause, the reasonably far-sighted bond fund manager may find the latter more attractive because of its potential for far greater liquidity come 1999.
“There will be two sorts of deals from now on,” says Steve West, managing director at SBC Warburg, joint lead manager in the EIB euro issue, “those that can be built on and those that can’t. They’ll look the same and smell the same, but you won’t be able to deliver one in place of another they’ll be different bonds with different item numbers. Post-1999, how will you differentiate between issues? It will be purely credit and liquidity. Fund managers will choose the most liquid bonds available.”
Two ostensibly identical euro-denominated bonds in 1999, then, will not be fungible with one another if they were issued with the two different further-issue clauses. SBC Warburg’s West estimates that up to a third of outstanding debt in the Euromarkets will be based on the technical and legal specifications that the EIB has put into place now with its recent debt issues. As bonds mature and are refinanced, the constitution of the market will change moving to wholly fungible securities. “We’re not talking about 1999, it’s happening now,” says West.
Although the EIB has “the highest probability of being the most active in issuing debt,” says Brace Young, managing director in the fixed-income division of Goldman Sachs International in London, other issuers active in the European markets look equally likely to take into account both Emu and questions of liquidity. German multinational Siemens has issued bonds that are similarly fungible into the euro.
The EIB move is explicitly designed to bring the single currency closer to reality. “As the European Union moves towards monetary union,” says Goldman Sach’s Young, “a number of the supranationals in Europe will play a prominent role in the process.” He continues: “Because the EIB is a supranational without a sovereign currency it is in a constructive position to take advantage of the single currency.” The EIB itself says that the recent guilder and euro issues are part of “a long-term strategy to support Europe’s monetary union and economic integration.”
In the past six months currencies that do not look likely to join Emu in the first wave, such as the Danish krone and the pound sterling, have been attractive for that very reason and, as Goldman Sachs’s Young says: “Supranationals will continue to do opportunistic financing in any currency that suits their current lending targets.” Therefore, although those issues that do not have the fungibility clause will be much less attractive for fund managers, borrowing in “fringe” Emu currencies such as sterling will remain a part of the supranational game plan. “Whatever wrinkle in the market allows them to do that, whether it’s currency-specific, maturity-specific or structure-specific, it will continue to be important in the way that they finance themselves,” he says.
The new further-issue clause will have a major effect on European bond markets. But the full impact of the EIB’s move is not yet understood. “A lot of people will tell you that this isn’t significant and it’s just an automatic conversion where in the past it was manual. But there is an argument to say that we are seeing a sea change in the way that the offshore markets, particularly for European currency debt, operate,” says West. “What do you do with a 10 billion deal that doesn’t have the new clause? You can’t build it into a bigger deal except in that currency. If you issue the same thing today with the right documentation, you can.”
One advantage of the potential for complete fungibility between issues is that of a benchmarking effect. Debt is useful when it is traded in a way that allows supranationals to demonstrate where their paper is in relation to others. The World Bank, for instance, has been prominent in large, benchmark global issues that have had the effect of forcing down World Bank spreads over the government market on which the debt is based. This has had the effect of reducing its borrowing costs and creating debt that others use as a benchmark.
The EIB has stated that it wants to create a euro benchmark yield curve. The bank may have made the first move in a game of euro benchmarking in which all supranationals and issuers on the European debt markets will eventually take part.
