Local currency bonds take centre stage

Fri Feb 1, 2013 11:09am EST

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* Big inflows into local currency funds

* Eurorouble and Eurolira bond issuance spree

* Bankers warn about over-supply and demand constraints

By Sudip Roy

LONDON, February 1 (IFR) - Investors are wading back into emerging markets local-currency bonds, enticed by the prospect of higher total returns than in the US dollar market. But some bankers question whether investors are becoming too greedy and ignoring the risks in their pursuit of yield.

Over the past four weeks, local currency funds have taken in a cumulative USD4.4bn of net inflows, according to EPFR Global. That accounts for more than 60% of overall allocations to emerging markets bond funds over that period and is double the amount invested in hard-currency funds, as investors seek ways to maintain last year's stellar performance.

In 2012, nearly all emerging markets bond indices delivered double-digit total returns, according to JP Morgan, although the US dollar-based asset classes fared best. The NEXGEM index, which tracks frontier markets, led with a total return of 21.6%, followed by the sovereign-focused EMBI Global with 18.5%. These compare with the 13.7% posted by the local-currency GBI-EM Global Diversified index.

This year, given the volatility in the Treasury market and the tight spreads at which dollar debt is trading, similar returns will be harder to come by, especially from sovereign bonds. So investors are emphasising alternative strategies with local currencies at their heart.

"I believe that emerging markets local-currency bond returns will deliver marginally lower returns than they did last year, but are most likely to outperform hard-currency emerging markets bond returns as emerging markets currencies appreciate versus the US dollar," said Thanos Papasavvas, strategist, fixed income and currency team at Investec Asset Management.

One of the biggest beneficiaries of the flows, which began to accelerate at the end of last year, is the Russian funds sector, which in December saw an increase for a second month to 9.1% of assets under management from 8.9%. This represents the largest allocation since June 2008.

These inflows are in turn feeding supply in the Eurorouble market, so much so that Eurorouble issuance is one of the most significant trends in the CEEMEA debt capital markets. Already in 2013, Russian borrowers have raised Rbs70bn (US$2.3bn) in rouble-denominated Eurobonds, compared with the Rbs90bn raised during the whole of 2012.

Arbitrage

For Russia's banks in particular, borrowing in Euroroubles is a no-brainer given the arbitrage opportunity. "For Russian lenders, the rouble Eurobond market is the cheapest form of borrowing across wholesale and deposit funding," said William Weaver, head of CEEMEA debt capital markets at Citigroup.

Sberbank's recent Rbs25bn 7.00% three-year bond, for example, came 95bp back of the government OFZ curve, whereas its 4.95% 2017 dollar bonds trade at a 125bp premium to the Russian sovereign's 3.25% 2017 notes in the US market.

For investors, the attraction is the extra yield on offer. "The low global yield environment is pushing money into these markets," said Binqi Liu, emerging markets portfolio manager at HSBC Asset Management.

Russian Agricultural Bank, for example, printed a Rbs10bn five-year bond last week at 7.875%, compared with its May 2018 dollar bond, which is trading around 3.7%.

On an absolute yield basis, international investors are getting more than double by buying the Eurorouble bond, while the total return will be nudging 10% once the rouble's appreciation against the dollar is included.

It's not just the Eurorouble market that is active. Last week saw the first ever Eurolira transaction from a Turkish entity after Akbank printed a TL1bn five-year bond. Others are likely to follow.

Grab for yield

Some bankers, however, worry that the issuance spree is just a fad. "Investors are getting greedy and losing sight of the risks," said one. "It's just a grab for yield."

One of the problems is that these markets are untested and there's a limit to how much supply they can take in one wave. This week's bond by RAB, for example, was trading down in the secondary market on fears of over-supply and follow-on demand constraints. Another borrower, Novatek, has held back its Eurorouble deal to wait for better conditions.

"It's a bespoke market," said one banker, who added that there's a limit to the number of investors sophisticated enough to fully comprehend the credit and FX risks involved.

In a technical point, he said that borrowers should seek to issue bonds under a 144a structure rather than Reg S only to allow sales into the US, where the more knowledgeable institutional accounts tend to reside.

More generally, while the yield pick-up on offer cushions investors against a degree of local-currency depreciation, history shows that fortunes can turn quickly. In 2011, gains generated in the first eight months of the year were wiped out in a matter of weeks as markets became worried about a eurozone collapse.

That fear may have subsided for now, but investors need to be wary of other risks, not least regional and country divergences. Talk of currency wars could lead to further intervention by some central banks and even capital controls.

As Liu said: "When there are big sell-offs, especially with dealers running smaller balance sheets, the door to the exit is narrower. That is a risk."

However, Papasavvas noted that investors took advantage of the weakness in 2011 to increase their exposure to emerging markets local currencies and bonds. He expects the fund flows to continue.

"There are five key reasons: the improving structural emerging markets story; the attractive risk/return characteristics; the contained correlations versus other traditional asset classes; the crisis in the developed nations; and the expected emerging markets FX appreciation." (Reporting by Sudip Roy; Editing by Julian Baker and Matthew Davies)

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