The inexorable rise of Sovereign Debt
The trend over the last ten years has been the move to funding in your domestic debt market. Sovereign issuers are able to do that right now because, on the demand side, there are foreign pension funds, domestic pension funds and insurance companies providing a buyer base for domestic currency debt.
“In the past when people focused on the sovereigns and emerging market debts, they would talk about dollar bonds. That asset class is still around, but it’s slowly shrinking,” says Joel Kim, Head of Asian Debt for ING Investment Management, Asia Pacific.
“The market development over the past five years has been the movement of allocations to local currency debt for various reasons, including [capital] growth. Domestic currency debt markets in emerging markets are at least ten times bigger than the external debt markets of those emerging markets.”
Another reason for the movement from US dollars to local currency is that dollar debt no longer offers the diversification benefit it once did, as local currency debt markets strengthen and become more liquid, says Kim.
Glenn Maguire, Chief Economist, Asia Pacific, for Société Générale Corporate and Investment Banking, says domestic consumer demand in Asia for goods and services in emerging markets may be a factor in driving demand for local currency debt, even in countries with large current account surpluses, such as China.
“It’s not that there’s a problem with capitalising banks in Asia at the moment, but ultimately sovereign bond issuance is a good way of providing mortgage funds,” says Maguire. We are seeing a number of economies move to this. Developed economies such as Australia, and emerging markets such as China have all provided first home ownership from funding raised by the issuance of sovereign bonds.”
Peter Eerdmans, Head of Emerging Market Debt for Investec Asset Management, is another who believes there is good opportunity in local currency markets currently: “We think bond yields can come down a lot further on the back of lower inflation and central bank rates being low. The additional return you can get is from currency appreciation. I think sovereigns will build on their local currency bond markets and I think more corporates will start to use them.”
In terms of foreign investors gaining exposure to Asian debt, either via securities invested indirectly in mortgage markets, or via the direct loan markets, Joel Kim of ING Investment Management says he doesn’t currently see many opportunities: “The typical driver for securitisation in markets outside Asia is that you need to clean up your balance sheet. That’s going to be tough for the banking system here in Asia, where there’s plenty of liquidity to go round. So the motivation for banks to do this has never really been there.”
“I’m sure people are looking at the loans market, but especially at this time when loans are cheapening significantly in other parts of the world, I’m not sure if there’s much of a value proposition for it. The simple reason is that with excess liquidity in Asia, the pricing of these loans is not necessarily going to be as attractive as elsewhere –particularly at this stage of the credit cycle.”
Liquidity in the banking sector is not however uniformly high across Asia, meaning there are opportunities to build the corporate bond market in local currencies in emerging economies. “In some markets less funding is coming through banks so people are trying to create capital markets in the emerging space. Corporates are issuing bonds to raise funds that way,” explains Kim. “Asia has always been quite bank-centric, and the corporate debt market has never really taken off in the way it should,” he adds.
Part of the problem is that unlike the European Union corporate bond market, in Asia there is no actual or de facto local currency in which to price corporate debt; create high levels of liquidity; and form a truly regional rather than simply national market for such debt. “You need to be able to tap into liquidity from investors, for example, in New York. If you need to raise the equivalent of a billion dollars, there’s no way as a corporate that you can raise that in Thailand,” says Kim.
Peter Eerdmans suggests that mitigation of currency market risk could provide an incentive to smaller companies to seek corporate debt in local currency. “In a way, having dollar debt in this environment is quite difficult for corporates. If they see their currency fall 40% against the dollar, then their debt service will have gone up quite substantially, and their debt repayment has grown. This is particularly true for corporates that don’t have a lot of exports, and they don’t have a lot of dollar inflow.”
In 2009, Investec believes the duration story is a good play. Eerdmans says, “We think this is the time to extend exposure along the yield curve. We argue this bond market rally has further to go. We think particularly that those bond markets that have seen a sell off due to liquidity issues could see a reversal and a catch up with other markets.Markets such as Indonesia, Mexico, Brazil and Colombia where we think that on the back of much lower inflation, central banks cutting rates and slower growth, there is value in the longer bonds.
“In Asia, I think Indonesia is probably most interesting, but it is extremely volatile, so you do get hit by wide spreads, but in the longer term I think there is a lot of value in that market compared to its peers.”
Other Asian bond markets with liquidity issues can be accessed via derivative products. Eerdmans explains, “In Taiwan, the Philippines, China, India and maybe some frontier markets like Pakistan and Vietnam, it’s easier just to play the currency through non-deliverable forwards rather than trying to get the debt which is often very illiquid.”
He acknowledges though that in the current climate, investor appetite for debt derivatives may not be strong. “We were starting to see the development of swaps and futures in the emerging markets in 2007, but because of market conditions in 2008 those things stalled. I do think though that if things settle in 2009 they could come to the fore again.”
“Most of these bond markets have seen very strong rallies in recent months - the big worry in the first half of 2008 was inflation, and we saw massive sell-offs on the back of that, with central banks being perceived as being behind the curve. Then things turned sharply from July. We actually put out a statement at the end of June arguing that the market’s fears of inflation were overdone and that commodities were probably reaching a peak, that it would be useful to move to a long duration position and that it would be a good opportunity to buy bonds. That has worked well in most markets, where we have seen rallies, growth coming off sharply and central banks cutting their rates.”
Good returns are to be had from being part of the whole convergence of emerging markets through sovereign bond markets. Transparency of markets in terms of the ability to benchmark products, care on timing and the need to spread risk remain important factors.
Given that sovereign bonds have a generally good track record regarding default risk, an important question is whether current price levels are an accurate reflection of market risk or linked more specifically with current market mood. “If you look at the typical credit metrics that an emerging market analyst would look at in terms of vulnerability across emerging markets, then things look a lot better now than ten years ago,” says ING’s Joel Kim.
“There’s very little reason to believe that in the current market you’re going to see a long list of sovereign defaults. Credit character can be a factor, but not usually in Asia. It tends to be more of a concern in Latin America, where one could argue from a macro perspective that things have not always been managed appropriately.”
Peter Eerdmans agrees: “Currently there’s a lot of liquidity premium that attaches not just to sovereign bonds but also corporate bonds. The market is priced as if half of them would default over the next five years. That is certainly not something we are projecting, and I don’t think many other market participants are either.
“Purely on fundamentals, prices are at distressed levels. But there are a lot of people who have been way too leveraged. So from a buyer’s point of view it is quite rational to say ‘I’m going to wait for those sellers to go through the market at distressed prices. I’ll see where this ends and then I’ll put my cash to work.”