IN EVERY EMERGING-MARKET crisis, the country in question has too much foreign currency debt. Indeed, if any country’s debts are in dollars while its revenues are in rapidly depreciating pesos, the end result is sadly predictable. And yet countries continue to issue tens of billions of dollars in foreign-currency bonds, just because they need the money and foreign investors have no interest in buying obligations denominated in pesos. All this is beginning to change, however. During 2004, local markets were the hot new asset class in the world of emerging-market fixed-income investing. Investment banks took notice, and Uruguay and Colombia both came to market with Eurobonds denominated in their domestic currencies. With these bonds, there are no worries about domestic taxes or custody arrangements: the only thing making them different to any other Eurobond is the currency in which the coupon is calculated.
“This is one of the best developments in emerging markets,” says Richard McNeil, head of Latin debt capital markets and global liability management at Goldman Sachs.
Sin and redemption
McNeil’s enthusiasm is shared by Chris Gilfond, co-head of Latin capital markets at Citigroup, who likes to reference the famous concept of original sin, as put forward in 1999 by Ricardo Hausmann, then chief economist of the Inter-American Development Bank. The difference between developed and developing countries, Hausmann said, was that the latter could not borrow at long tenors in their own currency. Consequently, when a crisis hits, a developed country can soften the blow by cutting interest rates, while a developing country has to exacerbate it by raising them.
If Hausmann is right about original sin, says Gilfond, then the new-found ability of Latin American countries to borrow at long tenors in their own currency must constitute Paradise Regained.
The trail was first blazed by Uruguay in October 2003, with an inflation-indexed bond with a face value of 5.6 billion Uruguayan pesos, or about $200 million. It was the country’s first bond issue since its debt restructuring, and it was a blow-out: the deal was upsized from an initial Ps4 billion, or around $150 million. Investors loved the 11.5% real yield, especially when they knew that the Uruguayan peso was undervalued and much more likely to strengthen than weaken against the dollar.
With the exception of the inflation indexing, the bond, which was lead managed by Citigroup, set the benchmark for how to do such things. In every respect but the currency it was just like any other sovereign Eurobond: it was fully SEC registered and pari passu with all other global bonds. Even the currency of the bond was technically dollars: the coupon is calculated in Uruguayan pesos, and then converted to dollars at that day’s exchange rate, so that there’s no problems with foreign exchange.
After Uruguay came Colombia. The Colombians were hesitant at first, unsure about how their local market would react to foreign issuance. But when emerging bond markets started rallying in the second half of 2004, Citigroup persuaded them that a global issue would price inside the curve of the domestic TES, as the local treasury securities are known.
“A global issue has to be below the local curve,” says Catalina Villa, head of international capital markets at the Colombian finance ministry. In the event, the most positive aspect of Colombia’s first domestic-currency bond issue for the sovereign was not the fact that it managed to come inside the domestic curve but that the entire domestic treasury bond market rallied as a result.
Not only did Colombia raise money abroad more cheaply than it could manage domestically, it also lowered its cost of money at home. On top of that, a good 30% of investors in that first bond had never owned Colombian debt before, so the country managed to broaden its investor base as well.
Now that Colombia has issued its bonds it can look at market swap rates and work out which money is relatively cheap and which more expensive. (The swaps do not exist with remotely enough liquidity to enable the markets to arbitrage the gap.) Dollar-denominated debt, says Villa, is the most expensive debt of all. Then comes local peso-denominated debt, and finally foreign peso-denominated debt: only funds from multilaterals such as the World Bank and Inter-American Development Bank are cheaper than this new source of funds.
How long this state of affairs will continue, however, is unknown. “As the dollar has gone lower, we’ve seen a lot of demand for these issues, but the window of opportunity is not going to stay for ever,” says the head of debt capital markets at one bank that has been involved in such deals. “By the end of 2005, the window will have long disappeared.”
A long-term local view
Others are more optimistic. Paul DeNoon, emerging-markets fund manager at Alliance Capital Management in New York, says that “a lot of us are looking at this as a decent medium-term investment”. One of the things that DeNoon likes most about these bonds, he says, is that “you can play a currency and the bonds separately”. Contrary to the fears of the investment banker, DeNoon says that he’s not (or not only) buying these instruments just because you get a huge carry along with capital gains when the dollar weakens.
What’s new is that DeNoon and investors like him can now express a view on long-term Mexican interest rates, which might not behave in exactly the same way as the long end of the Mexican dollar curve. Both, however, are the kind of investments that are driven much more by the prospects for the economy over the next couple of decades than they are by the prospects for the dollar over the next couple of months. Bankers who have underwritten these deals say that many of the investors in them are hedging their short-term currency exposure, wanting to take pure credit risk.
Indeed, anybody buying long-dated dollar-denominated bonds, from any country, is ultimately taking more of a view on long-term US inflation than they are on the long-term inflation prospects of the country whose bonds they are buying.
If you want pure emerging-market risk, local-currency bonds would seem to be the way to go.
The bonds are clearly good for the issuing countries, too. “Getting away from dollar-denominated borrowing and developing better local-currency bond markets will help to insulate a lot of these economies from potential crisis,” says DeNoon. Mexico is a prime example of a country that can meet all of its financing needs in its domestic market, thereby greatly reducing the prospects of repeating the tequila crisis of 1994-95, when a huge devaluation meant skyrocketing sovereign debt.
But emerging-market countries can still suffer huge devaluations, and foreign investors are still going to be much more comfortable, generally, in dollars than they are in pesos. This is why Uruguay’s second local-currency issue, in July 2004, – of something that the lead managers decided to call devaluation protected notes, or DPNs – was so interesting.
The bond carried a fixed-rate coupon, rather than one linked to inflation, of 17.75% – just over 8% in real terms, a large drop from the 11.5% real coupon paid eight months previously. But the coupon isn’t necessarily 17.75%. If the Uruguayan peso devalues by more than that amount, on an annualized basis, between one coupon payment date and the next, then the coupon is not 17.75% but rather the rate of devaluation of the currency.
It’s a clever structure, although it’s also one that doesn’t protect the issuer in the event of a crisis nearly as much as a plain-vanilla bond would. What’s more, it’s unclear how much foreign investors will be reassured by their dollar-indexed coupon: if the Uruguayan currency is depreciating at a rate of more than 20% a year, they’re likely to be selling their bonds even if the coupon payments are not falling in dollar terms.
In any case, whether it was thanks to the devaluation protection or simply due to the 17.75% coupon, the bond issue was an enormous success, and ended up getting upsized to $250 million from $150 million.
The investor base was half again as large as the original investor base for the bond at the end of 2003, and started attracting a whole new set of investors to the local-currency asset class. “The success of the DPN wasn’t evident until we did the Colombia transaction with more than 85 investors,” recalls Citi’s Gilfond.
Colombia, in turn, got more people interested: not just investors, but also issuers. “After the first issuance in November, we received interest from other sovereigns trying to develop this type of product,” says Colombia’s Villa. Her advice to those sovereigns? “They have to be careful about the tenor and the size.”
Colombia started short and small – $375 million and just over five years in duration – despite huge demand for its peso-denominated paper. Villa wanted to leave investors wanting more, and also wanted to build out the new Europeso curve slowly and carefully. One bad deal at the beginning could sour the entire asset class for years to come.
As things turned out, however, the problem was not that countries would rush in to the new asset class with oversized deals: quite the opposite. Despite rumours that Peru might be interested and feverish speculation that the 800-pound gorilla of the emerging-market debt world, Brazil, would issue a real-denominated global bond, no other countries followed the lead of Uruguay and Colombia. For while these bonds can be great for some countries, they’re by no means good for everybody.
At this point the market has largely given up on its hopes for Peruvian issuance, for instance: it is generally understood that finance minister Pedro-Pablo Kuczynski is opposed to the concept. Kuczynski is a very smart man, who understands financial markets arguably better than any other Latin finance minister, so it’s worth wondering why he might take that view.
One possible reason is that a domestic-currency issue might simply not make economic sense. If you are in charge of a strong and growing economy whose currency is likely to strengthen against the dollar, you suffer both a negative carry and a capital loss when you issue in your domestic currency rather than in dollars. To simplify: why pay 17% in pesos when you can pay 7% in dollars?
Sending the wrong signal
Doing so could also send entirely the wrong signal to the markets. The issuing country only benefits from domestic-currency issuance if its currency weakens, and so the new bonds are inevitably going to raise investors’ questions about why the country is worried about such a possibility.
But the chances are that Kuczynski’s aversion to a foreign sol-denominated bond are not nearly as theoretical as that. Rather, Peruvian domestic interest rates are much lower than those in Colombia and Uruguay, and he has a captive audience of pension funds at home that will lend the government money at extremely attractive rates. Colombia and Uruguay both have sufficiently high domestic interest rates and sufficiently liquid domestic markets to mean that they found it cheaper to raise peso-denominated capital abroad. Peru, on the other hand, has a much less well developed domestic market, which means that it could probably never issue a sol-denominated bond inside the domestic yield curve. And if you can’t save money by issuing one of these bonds, the arguments for going ahead anyway are pretty weak.
In Brazil, most bankers agree that the government could probably issue long-dated real-denominated debt abroad at levels cheaper than it pays domestically. A handful of Brazilian banks have already opened up the market, taking advantage of their foreign subsidiaries to raise real-denominated funds: most Brazilian companies will never issue in reais abroad, because the tax consequences when the proceeds are brought into the country are prohibitive. Banks get around that problem by keeping and lending their reais offshore.
And there’s certainly a lot of demand from foreign investors for Brazilian paper without the hassle of Brazilian markets. “To get into the Brazilian market, invest in Brazilian treasury bills, and get out, you face a bewildering array of regulations and taxes,” says a capital markets banker. Brazil is a big enough market to encourage many foreign investors to go through the hassle of investing in its domestic bonds anyway, but that universe of investors could be broadened enormously if Brazil issued real-denominated bonds in New York or Europe.
Part of the reason why Brazil is wary of entering the market is precisely because it is so attractive at the moment. It has been raising domestic interest rates to try to keep inflation under control, which means that if it did issue in reais, the amount it would pay would be much higher than the country’s credit fundamentals might suggest. If, like Colombia, it wanted to start at the short end of the curve and work out, it would essentially be borrowing money at the very top of a yield curve that is already artificially high.
“Brazil has not stimulated portfolio fixed-income investment because it would attract the carry trade,” says one senior Brazilian banker. “They are not very excited about attracting a lot of speculative short-term money.”
What’s more, says a rival banker in São Paulo, “it would be sending a signal that it is comfortable with interest rates at that level” – something that would raise a firestorm of political opposition.
Another large obstacle to issuance in the case of Brazil is, ironically, precisely those taxes that keep foreigners out of the Brazilian fixed-interest markets and hoping for issuance in New York. After all, when Brazil issues offshore, it is not collecting taxes on that issuance.
So in order for it to be worth Brazil’s while to issue in reais abroad, coming to market through the domestic curve wouldn’t be enough. The foreigners would have to pay so much more for their bonds that it would make up for all the lost tax revenue that Brazil receives when it issues domestically. That’s unlikely: Brazilian banks are expert arbitrageurs, and would never allow much daylight between the real curve in Brazil and the real curve abroad.
In any case, the foreign investors who are most interested in Brazil’s high interest rates are good sources of Brazilian tax revenue themselves. “You have demand for long-dated paper in reais, but if it’s only hedge funds, you might as well let them come into Brazil and buy the local paper,” says a banker who has talked to officials at the Brazilian finance ministry about the idea of issuing abroad.
Indeed, there is really no reason why countries should build out parallel yield curves in their domestic currency rather than simply attract foreign investors into their own treasury markets. Mexico is by far the world leader in this respect. While Uruguay and Colombia were making headlines, it was quietly selling more than 90% of its benchmark MBono20 20-year bond to foreign investors. And when the Mexican market sold off at the end of 2004, it was those same foreign investors who stepped in to provide a floor and start buying, even if the domestic pension funds were selling.
A superior model
It doesn’t take much pushing to persuade Colombian finance ministry officials to admit that Mexico’s model, where foreign investors go to the country, is superior to Colombia’s model of the country taking itself to the foreign investors. But for a relatively small country like Colombia to attract that kind of foreign portfolio investment, it would need an extremely open and transparent currency regime. Instead, the Colombian central bank is moving in exactly the opposite direction, implementing currency controls and worrying that if foreign investors get involved in the Colombian treasury market, then they could wreak havoc if, in the event of another emerging-markets crisis, they all decided to leave at the same time.
But while it is true that foreign investors can hurt a domestic treasury bond market if they’re heavily invested there, it’s also true that they can hurt it if they’re not. “Look at Brazilian C bonds and how they trade during crises,” says Goldman’s McNeil. “Often the transmission mechanism works through C bonds into the domestic markets, since Brazilian banks actively trade external debt versus domestic debt.”
In other words, keeping foreigners in New York rather than in Bogotá is unlikely to do much to prevent contagion. DeNoon says: “If the Colombian market comes way off, the locals are going to sell the domestic market and go offshore. I don’t think it insulates you one way or the other.”
And the advantages of having one market in domestic government debt are clear. Mexico has certainly benefited from its completely open system, which welcomes investors from around the world with open arms and no withholding taxes.
There are 32 different countries at least some of whose domestic treasury bonds settle currencies in the Euroclear system. The only emerging markets on the list are Hong Kong, Indonesia, Malaysia, Mexico, the Philippines, Russia, Singapore, Thailand, and Argentina – that last largely for historical reasons. Of those countries, Mexico has done the most to make all of its bonds Euroclearable and to try to attract as many foreign investors as possible into its treasury-bond market. Pablo Venturino, head of Latin credit markets origination at ABN Amro, says: “Mexico is light years ahead in terms of lowering the barriers for foreign investors to participate in local markets”.
And the investors love Mexico back: Alliance’s DeNoon calls it “the success model”. Yes, there are slight idiosyncrasies to domestic bond markets that you don’t get with global bonds: different day-count conventions, for instance, which can make it hard to compare implied rates of return. And in terms of documentation, there’s no doubt that global bonds put creditors on a stronger footing: they’re pari passu with all foreign debt, they are issued under New York law, and if the country defaults, you can get a court judgment against it. None of that is true of Mexican treasury bonds.
But anybody buying Mexican bonds at this point in the market cycle is not going to still be holding them on the other side of a default in any case. Much more important is the liquidity that can only be achieved through one unified market: the ease of getting in and out of Mexican paper more than makes up for any difficulties in working through the documentation.
Not all countries are in Mexico’s position, however. Uruguay and Colombia could have tried to go down the Mexican route, and open up their domestic markets rather than simply issuing bonds abroad. It would have taken much longer. As Goldman’s McNeil notes: “At the margin it’s much easier to do a bond issue than to do a wholesale revamp of your foreign-exchange regime.” And because it would have taken longer, those countries might have missed their window of opportunity for introducing foreign investors to local-currency instruments.
What’s more, even if they did open up their treasury markets, there’s no guarantee that foreign investors would flock to Uruguay as they did to Mexico.
“It’s nice to be Mexico,” says Citi’s Gilfond: a large company like Alliance can certainly justify the cost of working out how to enter the Mexican market. It’s an enormous north American economy that no global investor can afford to ignore. Uruguay, on the other hand, isn’t. If the Uruguayans want foreigners to buy their debt, they’ll probably need to go to the foreigners, rather than wait for the foreigners to come to them. As Gilfond asks: “Are people going to make arrangements for custody in Montevideo?”
Over time, then, different countries are going to approach how to attract foreign investors into their domestic currencies in different ways. Poland might follow the Mexican model, or even go one step further and join the single European currency. A country like Venezuela or Thailand, on the other hand, will probably gravitate towards the Euromarkets. Either way, foreign investors are going to have to start getting much more comfortable with currency-related volatility alongside their credit risk. Gilfond calls it “the next generation, the evolution of the asset class”.
