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A Fresh Perspective on Accessing Local Currency Markets

• Supranational agency FX linked bonds were once instruments that emerging market investors avoided, but we believe developments in these bonds make them appropriate in a limited size in portfolios.
• The changes in the cost of USD borrowing in emerging markets is leading to more attractive yields on these bonds relative to local currency government bonds in some markets.
• Technical changes in the market structure of these bonds are increasing the attractiveness of these bonds, even if or when the USD borrowing costs no longer favor investors.

Supranational agency foreign exchange (FX) linked bonds in emerging markets have traded for many years.  These bonds were sold to investors as a way to access local currency and yield exposure at a higher credit rating without any of the operational complexities of local settlement.  Less discussed, however, were the significant risks of limited liquidity and lower yields these bonds carried compared to local currency government bonds.  Investors were wise to avoid these supranational bonds given those risks outweighed the benefits.  Emerging markets and market structure, however, are always evolving.  Recent developments in the supranational market are worth re-evaluating.  Investors may find new opportunities for these bonds in a limited part of their portfolio.

Historically, the major downside of the supranational FX linked bond market was investors earned a lower yield with a worse liquidity profile than local currency government bonds.  Liquidity constraints were an outcome of the structure of the market and the investor base.  Banks issued bonds with small notional size across a large number of securities rather than the reverse.  Additionally, most banks only supported secondary trading for the bonds they issued, resulting in large numbers of individual securities with the support of only one market maker.  The homogeneous investor base results in liquidity problems because of herd mentality. Local currency government bonds, however, provided significantly more liquidity because of a more heterogenous investor base, fewer individual bonds and a wider variety of market makers on any given bond while often offering higher yields.

Today, the market factor largely responsible for making these bonds more attractive to emerging markets bond portfolios is local currency borrowing in USD as reflected in the cross currency basis.  The agencies issuing these bonds swap the proceeds back to USD via derivatives so a portion of the more favorable cross currency basis can be passed on to investors.  Recent issuance yields have reflected a large portion of this basis and it can be seen in secondary market levels.  The development of cross currency basis swaps and other derivatives, like NDFs, in more emerging markets has also provided additional tools for market makers to hedge these bonds. Therefore providing additional secondary liquidity on top of the increased yield from the basis.

While these favorable market conditions change and fluctuate over time, there are also some technical developments favoring the inclusion of these bonds in a limited part of an emerging markets portfolio. First, bonds have recently become more concentrated in a fewer number of issues as banks re-tap existing securities rather than continuously create new ones.  Second, supranational FX linked bonds are not subject to local taxes, giving them a potential significant advantage over local bonds in certain markets when comparing after tax yields.  Finally, supranational FX linked bonds are not subject to local capital controls and there are now examples of these bonds paying off despite being denominated in currencies where capital controls were imposed after the bond issuance.

Local currency government bonds still generally have a more favorable risk/reward profile despite all of these changes in the supranational agency FX linked bond market.  EM managers must therefore maintain robust trading infrastructure and expertise in these local markets. The calculation, however, is not all or nothing.  The difference today is the increased frequency of circumstances where the supranational bonds will have a more favorable profile than local bonds.  These bonds will still have a very limited role in portfolios, but they no longer need to be avoided entirely.  EM managers that fail to constantly review and reassess market developments and market structure will miss out on these types of opportunities.