Emerging Markets Local Currency Debt and Foreign Investors

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1 Emerging Markets Local Currency Debt and Foreign Investors Recent Developments Daniela Klingebiel Pension & Endowments Departments Nov. 20, 2014

2 Outline Structural trends in emerging markets (EM) external and local currency sovereign debt Development of size of EM debt market and composition Inclusion of EM debt in fixed income benchmarks Developments of foreign holdings in EM debt (local and hard currency) and their effects Why do foreign investors move into EM local currency bonds Strategic asset allocation and EM local currency bonds Opportunistic investing in emerging market sovereign local bonds How do institutional investors view local emerging markets bonds How do foreign investors access local emerging market bonds Investing through external managers Direct investing in markets ETFs 1

3 Structural trends in EM hard and local currency sovereign markets

4 Explosive growth of EM local currency debt Total EM debt outstanding (US $ bn) EM DX debt vs. FX debt outstanding (US $ bn) 16, , , , , , , , , , , , , , Emerging Markets Source: Bloomberg. United States EM FX Debt EM DX Debt The market capitalization of EM debt grew significantly during last 14 years. While sovereign debt outstanding for 55 emerging markets, amounted to $1.3 trillion in 2000, 13 years later it had grown sixfold to $6.3 trillion. With $6.3 trillion, EM debt outstanding now almost half of the size of the US Treasury markets, the world biggest and most liquid market. Growth in EM debt outstanding driven by local currency debt (EMDX). While EM external debt (EMFX) almost doubled over this period from $576 billion to $1.0, EM local currency debt grew sevenfold from 3

5 US $ bn EM external debt now presents only small portion of Total market cap of EM debt 6, , , EM DX debt as % of total EM debt 90.00% 85.00% 80.00% 75.00% Source: Bloomberg 3, , , EM DX Debt EM DX Debt as % of Total EM Debt 70.00% 65.00% 60.00% 55.00% 50.00% In 2000, local currency debt accounted for roughly 55% of outstanding tradeable debt in EM. By 2013, the share of EM local currency debt to 83% of total outstanding EM debt. 4

6 US $ bn Market highly concentrated with few issuers accounting for bulk of outstanding EM local currency debt 4, , , , , Top 10 EM DX stock as % of total EM DX debt 85.00% 84.00% 83.00% 2, , , Top 10 EM DX stock Top 10 as % of total EM DX debt 82.00% 81.00% 80.00% EM local currency debt market is highly concentrated with the ten largest issuers accounting for 81% of the local currency debt market and 74% of overall EM debt. With $1.3 trillion, China s market cap of outstanding local currency debt largest in EM space. 5

7 China, Brazil and India alone account for 50% of outstanding market cap of EM local currency debt Table 6. Top 10 Largest DX EMD Issuers Stock Comparison Federal government debt, all maturities, amounts outstanding, by issuer (In billions of US dollars) DX Stock (USD billions) DX Stock (% GDP) DX Stock (% of total EM DX Debt) Total Debt (USD billions) Total Debt (% GDP) Total Debt (% of total EM Debt) Country Dec-00 Dec-13 Dec-00 Dec-13 Dec-13 Dec-00 Dec-13 Dec-00 Dec-13 Dec-13 China , % 14.74% 26.29% , % 14.76% 21.85% Brazil % 40.62% 17.61% % 43.95% 15.82% India % 32.93% 11.93% % 32.93% 9.91% Mexico % 24.32% 5.92% % 32.14% 6.50% Turkey % 29.72% 4.70% % 36.55% 4.80% Poland % 41.07% 4.10% % 57.94% 4.81% Malaysia % 51.51% 3.11% % 52.74% 2.64% Russia % 6.88% 2.78% % 11.34% 3.81% South Africa % 36.13% 2.45% % 39.65% 2.23% Thailand % 29.36% 2.19% % 29.38% 1.82% 81.08% 74.19% China, Brazil, and India also have debt stock of local currency bonds that exceed $500 mn. Also interesting to note that largest issuers of local currency debt also issue very little hard currency debt. 6

8 Six of largest 10 issuers have investment grade rating and all are at least part of one index S&P Credit Rating 1 Local Currency Index Membership 2 Country Dec-00 Dec-13 GBI-EM EMLCTRUU LEGATRUU LCEMTRUU EMGBI WGBI China BBB AA- * * Brazil BB A- * * * * India BBB BBB- * * Mexico BBB+ A * * * * * * Turkey B+ BBB * * * * * Poland A+ A * * * * * * Malaysia A A * * * * * * Russia B- BBB+ * * * * * South Africa A- BBB+ * * * * * * Thailand A- A- * * * * * Notes: 1. Local currency long-term debt 2. GBI-EM = JPMorgan Government Bond Index Emerging Markets, EMLCTRUU = Barclays Emerging Markets Local Currency Government Bond Index, LEGATRUU = Barclays Global Aggregate Index, LCEMTRUU = Barclays Emerging Markets Local Currency Government Universal Bond Index, EMGBI = Citi Emerging Markets Global Bond Index, WGBI = Citi World Government Bond Index 7

9 From a regional perspective, Total EM sovereign debt outstanding concentrated in Asia and LATAM Total sovereign EM debt breakdown, FY % 11.32% 3.03% 3.10% Sub-Saharan Africa Middle East & North Africa East Asia Pacific Europe & Central Asia 20.73% 30.45% Latin America & Caribbean South Asia With 31.3% LATAM region highest share of total sovereign emerging market debt outstanding, followed by with 30.5%. 8

10 From a regional perspective, local currency debt outstanding concentrated in Asia Total EM local currency debt breakdown, FY13 Total EM hard currency debt breakdown, FY % 13.40% 3.33% 2.90% Sub-Saharan Africa Middle East & North Africa 45.86% 1.18% 1.55% 4.10% Sub-Saharan Africa Middle East & North Africa East Asia Pacific 6.67% East Asia Pacific Europe & Central Asia Europe & Central Asia 16.66% 35.31% Latin America & Caribbean South Asia 40.63% Latin America & Caribbean South Asia Asia dominates the EM tradeable local currency debt market. While LatAm and European emerging market countries dominate the EM external debt market. 9

11 Foreign ownership of EM local currency debt has increased significantly over last 6 years Foreign Ownership of Emerging Markets Local Currency Sovereign Debt Federal government debt, all maturities, amounts outstanding, by issuer (In billions of US dollars) DX Stock (USD billions) Foreign Holdings (USD billions) Foreign Holdings (% of DX stock) Country Dec-06 Dec-13 Dec-13 % of GDP Dec-06 Dec-13 Dec-06 Dec-13 China , % % 1.68% Brazil % % 16.10% India % % 1.23% Mexico % % 36.87% Poland % % 34.92% Turkey % % 21.53% Malaysia % % 29.40% Russia % % 24.75% South Africa % % 37.85% Thailand % % 17.41% Philippines % % 14.44% Colombia % % 6.43% Indonesia % % 30.01% Egypt % % 0.21% Hungary % % 40.36% Argentina % % 3.20% Ukraine % % 4.83% Romania % % 22.30% Peru % % 51.08% Lithuania % % 16.09% Bulgaria % % 0.98% Sources: IMF Sovereign Investor Base Dataset for Emerging Markets, Arslanalp and Tsuda (2014) For a number of countries foreigners constitute an important part of the investor base. In 10 of 21 countries for which information was available, foreign investors hold at least 20% of outstanding local currency holding. In 6 countries, foreigners hold at least 30%. 10

12 Foreigners are an important investor base for a number of EM countries issuing local currency bonds Universe covered by IMF study included 21 countries accounting for roughly 89% of the EM universe covered in our analysis. For these 21 countries, foreigners hold 13% of total debt outstanding. In 16 countries, foreigner account for a significant higher share of local currency bonds. Also interesting to note that two largest issuers of domestic currency bonds, China and India, have little foreign ownership. A couple of countries, Egypt and Argentina saw a significant drop in foreigners holding local currency bonds, each for different regions. 11

13 Foreign non-banks (retail and institutional investors) important and large investors in EM debt Foreign Ownership of Emerging Markets Sovereign Debt 2013 General government debt, all maturities, all currencies, by issuer 2013 Total Debt (USD billions) Foreign Official Foreign Bank Foreign Nonbank Domestic Central Bank Domestic Bank Domestic Nonbank Total Foreign Total Domestic South Africa % 3.69% 33.52% 0.55% 22.28% 38.37% 38.80% 61.20% Egypt % 0.06% 2.57% 24.48% 43.10% 20.02% 12.40% 87.60% China 4, % 0.02% 0.07% 5.45% 91.72% 1.57% 1.26% 98.74% Indonesia % 4.93% 23.29% 14.94% 13.15% 13.26% 58.65% 41.35% Malaysia % 3.34% 20.33% 0.00% 23.89% 45.48% 30.62% 69.38% Philippines % 4.84% 20.40% 6.73% 32.08% 20.01% 41.18% 58.82% Thailand % 3.11% 12.43% 6.34% 21.72% 54.60% 17.34% 82.66% Bulgaria % 2.57% 10.28% 0.00% 41.45% 25.98% 32.57% 67.43% Hungary % 5.88% 38.29% 0.60% 21.52% 19.64% 58.24% 41.76% Lithuania % 2.07% 58.41% 0.39% 18.44% 9.45% 71.71% 28.29% Poland % 4.49% 33.82% 0.00% 25.11% 26.81% 48.08% 51.92% Romania % 5.28% 21.13% 0.00% 33.23% 12.70% 54.07% 45.93% Russia % 3.93% 17.96% 4.21% 40.74% 31.49% 23.56% 76.44% Turkey % 8.43% 20.77% 2.15% 46.43% 10.10% 41.32% 58.68% Ukraine % 1.81% 29.74% 30.36% 19.31% 4.71% 45.61% 54.39% Argentina % 1.69% 20.78% 42.95% 19.18% 4.49% 33.37% 66.63% Brazil 1, % 3.84% 8.87% 30.00% 22.55% 32.47% 14.98% 85.02% Colombia % 2.68% 16.38% 0.06% 20.23% 49.57% 30.14% 69.86% Mexico % 6.78% 34.23% 0.00% 8.17% 42.37% 49.46% 50.54% Peru % 9.35% 30.00% 1.49% 9.72% 29.12% 59.66% 40.34% India 1, % 0.14% 0.56% 9.14% 29.76% 55.29% 5.81% 94.19% Sources: IMF Sovereign Investor Base Dataset for Emerging Markets, Arslanalp and Tsuda (2014) Notes: This data series covers general government debt, both local and hard currency. This chart is not comparable to previous tables on foreign ownership of local currency federal government debt securities. Foreign Central Banks and non-bank holders are largest holders of EM debt. 12

14 Effects of foreign ownership on local currency bond markets In a study for 10 emerging market countries, Peiris (2010) shows that greater foreign participation significantly reduce long-term government yield. Results were confirmed by Ebeke and Lu (2014). Peiris also found that increase in foreign participation does not necessarily result in increased bond yield volatility, but, could, in fact dampen volatility in some instances. In their paper, Ebeke and Lu s findings suggest that countries with strong macroeconomic fundamentals should experience less volatility. During the Taper tantrum, i. e. concerns about the end of QE in the US and the rise in US rates in middle of 2013, foreign ownership of local bonds remained relatively stable in most countries. Roughly 1/3 of countries actually saw increases in foreign ownership. Sources: IMF Sovereign Investor Base Dataset for Emerging Markets, Arslanalp and Tsuda (2014) Notes: This data series covers general government debt, both local and hard currency. This chart is not comparable to previous tables on foreign ownership of local currency federal government debt securities. 13

15 Inclusion in bond index positive for country as it increases liquidity in local market and demand for local bonds Index Name Ticker Inception J.P.Morgan Government Bond Index - Emerging Markets Broad/Diversified Market Cap (USD billions) GBI-EM Jun-05 1, Number of Constituents Country Criteria Liquidity Criteria Instrument Criteria GNI per capita below the Index Income Ceiling (IIC) for 3 consecutive years. i. Daily pricing available ii. Regularly traded in size at acceptable bid-offer spreads; readily redeemable for cash. iii. Low index replication costs. i. Fixed coupon or zero coupon. ii. Bonds with option features are excluded. iii. At rebalance date, maturity > 13 months. iv. No explicit face value minimum. J.P.Morgan Government Bond Index - Emerging Markets Global/Diversified GBI-EM Jan i. GNI per capita below the Index Income Ceiling (IIC) for 3 consecutive years. ii. Accessible to majority of foreign investors. Does not include markets with capital controls. i. Daily pricing available ii. Regularly traded in size at acceptable bid-offer spreads; readily redeemable for cash. iii. Low index replication costs. i. Fixed coupon or zero coupon. ii. Bonds with option features are excluded. iii. At rebalance date, maturity > 13 months. iv. No explicit face value minimum. J.P.Morgan Government Bond Index - Emerging Markets Diversified GBI-EM Jan i. GNI per capita below the Index Income Ceiling (IIC) for 3 consecutive years. ii. Directly accessible. No impediments for foreign investors. i. Daily pricing available ii. Regularly traded in size at acceptable bid-offer spreads; readily redeemable for cash. iii. Low index replication costs. i. Fixed coupon or zero coupon. ii. Bonds with option features are excluded. iii. At rebalance date, maturity > 13 months. iv. No explicit face value minimum. Citi World Government Bond Index WGBI Dec-84 20, Citi Emerging Markets Government Bond Index Barclays Emerging Markets Local Currency Government Bond Index EMGBI Dec EMLCTRUU Jul i. Minimum A- by S&P, A3 by Moody's for entry. Below BBB- by S&P; below Baa3 by Moody's for exit. ii. Fully accessible to foreign investors. i. Minimum C by either S&P or Moody's. ii. Fully accessible to foreign investors. No explicit liquidity criteria but minimum market size of at least USD 50 billion, EUR 40 billion, JPY 5 trillion for entry; below USD 25 billion, EUR 20 billion, JPY 2.5 trillion for exit. i. Minimum market size of at least USD 10 billion for entry; below USD 5 billion for exit. ii. Low index replication costs. i. World Bank Income group classifications of low/middle income OR International Monetary Fund (IMF) classification as a non-advanced country. Minimum market size of at least USD5bn equivalent. Additional countries that bond investors classify as EM. Ii. Market investability i. Fixed coupon ii. Investment grade iv. Minimum maturity of 1 year. v. Minimum issue size varies by market. i. Fixed coupon ii. Minimum C by either S&P or Moody's. iv. Minimum maturity of 1 year. v. Minimum issue size varies by market. i. Fixed coupon Treasuries. Inflation-linked bonds excluded. Private placements ineligible. ii. Investment grade, high yield, and unrated securities permitted. iii. Minimum maturity of 1 year. iv. Minimum issue size varies by market. Barclays Emerging Markets Local Currency Government Universal Bond Index LCEMTRUU Jul i. World Bank Income group classifications of low/middle income OR International Monetary Fund (IMF) classification as a non-advanced country. Minimum market size of at least USD5bn equivalent. Additional countries that bond investors classify as EM. Ii. Market investability i. Fixed coupon Treasuries. Inflation-linked bonds excluded. Private placements ineligible. ii. Investment grade, high yield, and unrated securities permitted. iii. Minimum maturity of 1 year. iv. Minimum issue size varies by market. In response to an increase in investor appetite, local currency debt indices were developed: the Government Bond Index-Emerging Markets (GBI- EM) series; index exists in three variations - the GBI-EM, GBI-EM Global and GBI-EM Broad - which cater to different investment objectives and inclusion criteria; the indices span over 15 countries and are also available in diversified weighting versions. 4 EM countries (Malaysia, Mexico, Poland and South Africa) are also part of the Citi World Government Bond Index that tracks the performance of local government investment grade bonds. And finally, the Barclays Agg Index now has a small portion of the index dedicated to a number of EMS. The weight of these indices, however, is below 3%. 14

16 AUM benchmarked against the JP Morgan sovereign indices amounts to $554 bn or 9% of outstanding debt Now $554 bn managed against various JP EM sovereign bond indices. Market cap of bond indices together account for roughly $3 trillion in EM market cap or roughly 50% of EM total outstanding debt. External debt still dominates. Despite its significantly smaller size, assets managed against hard currency index amount to $310 bn in 2014 up from $178 bn in Market cap of debt of countries allocated to index amount to roughly $830 mn, indicating that more than a third of outstanding debt is managed against the index. But assets managed against the EM local currency market index has increased ten fold from $21 bn to $221 in September

17 Why do foreign investors move into emerging market local bonds

18 Moving into EM local currency bonds involves Investing in EM local currency bonds entails two sets of decisions: Rate/Credit view reflecting a view of future monetary policy/ and development of fiscal balance. Currency view reflecting what extent home market currency may appreciate or depreciate vs currency of country. Easier for investors to express their view if they can separate decision: In order to do that need functioning interest rate swap market that allows investor to take exposure to market without taking on currency risk (to create synthetic exposure). Ability to hedge currency including through liquid fwd markets. 17

19 Why have foreigners increased exposure to EM local currency debt Anecdotal evidence and investor surveys suggests that increase in EM allocation since 2008 driven by search for yield given low level of interest rates in the US, Europe, and Japan after financial crisis. Inflows occurred against backdrop of significant improvements in economic fundamentals and policymaking from in EM. Improvements in fundamentals reflected in fact that now a large number of universe is rated investment grade. Inflows further supported by better liquidity in local markets and an overall improvement in debt issuance (larger market size). Up to 2013, Inflows also supported by view that EM currencies will strengthen given EM s growth differential with developed markets and their lower levels of debt. 18

20 Strategic asset allocation and emerging market local bonds Investors often use strategic asset allocation exercises to determine the optimal allocation to asset classes with a given desired risk spectrum. Typically the following considerations determine whether an asset class will be included in the exercise: Does an asset offer attractive risk and return characteristics. All else equal, a higher Sharpe ratio is more desirable as it indicates better rewards per unit of risk. Are the returns of the asset class normally distributed and risks thoroughly understood? Does the asset class capture any risk premium, if any. Is there any economic rationale for the risk premium and if any is this stable over time. Can it be captured through a passive exposure or does it require skill. Does asset have any diversification benefit vs main risk exposures of plan. Are diversification benefits stable. Liquidity. Is asset liquid and can it be easily traded. Is market for asset large enough that Plan s exposure not meaningful to overall market (to preserve liquidity) Is benchmark available to either allow for replication or for performance monitoring. 19

21 Institutional investors and their allocations to EM bonds No survey available that provides information on allocation to EM local bonds for institutional investors. Table on next slide reveals information of 16 US public pension plan with their allocation to EM local currency bonds. Plans are among 200 largest pension plans world wide according to a Tower Watson survey. Of 16 plans, 9 have allocation to EM local bonds. 8 of these allocations were part of the SAA. Notwithstanding in most cases, allocation quite small, ie below 5% of Plan assets. 20

22 U.S. pension fund exposure to local currency EM debt No. Fund Name AUM ($ billions) Exposure to DX EMD? Type of DX exposure (SAA or opportunistic) Exposure to FX EMD? Type of FX exposure (SAA or opportunistic) Allocation hedged? In % AUM 1 Federal Retirement Thrift No N/A None N/A N/A N/A 2 California Public Employees Retirement System 262 Yes Opportunistic No N/A No, but by policy currency must be convertible. 0.05% 3 New York State and Local Retirement System (NY State Common) No N/A None N/A N/A N/A 4 California State Teachers 166 Yes Opportunistic No N/A No 0.10% 5 New York City Retirement Systems No N/A None N/A N/A N/A 6 Florida State Board No N/A None N/A N/A N/A 7 Teacher Retirement System of Texas No N/A None N/A N/A N/A 8 New York State Teachers 95.4 Yes SAA Yes SAA - Global Fixed Income Securities Yes, by policy unclear 9 Ohio Public Employees Retirement System 88.5 Yes SAA - Emerging Markets Debt Yes SAA - Emerging Markets Debt Not completely - Non-U.S. dollar based securities are limited to 25% of the total Fixed Income assets. Target allocation of 3% (0-5% range) for the Defined Benefit Portfolio; 5% (2-10% range) for the Health Care Portfolio 10 Wisconsin Investment Board 83.9 Yes SAA Yes SAA Permitted but not required as per investment guidelines. 0.36%, cannot exceed 10% of global bond portfolio 11 North Carolina Retirement Systems 80 No N/A No N/A N/A N/A 12 Washington State Investment Board 79.3 Yes Opportunistic Yes Yes No, no formal policy across funds. 1.30% 13 New Jersey Public Employee's Retirement System 74.4 No N/A No N/A N/A N/A 14 Oregon Public Employees 70 No N/A No N/A N/A N/A 15 Ohio State Teachers 68 Yes Opportunistic Yes (majority) SAA No 0.38% 16 Virginia Retirement System 66 Yes Opportunistic Yes SAA - Credit Strategies Not required 0.71% 17 Massachusetts Pension Reserves Investment Management 53.2 Yes SAA - Value-Added Fixed Income Yes SAA - Value-Added Fixed Income No - by policy foreign investments are unhedged Target allocation of 2%. 21% of Value Added Fixed Income Portfolio invested in EM DX debt. 16% in hard currency. VAFI is 8.9% of total fund. 18 Iowa Public Employees Retirement System 24.8 No N/A Yes SAA - Credit Opportunities N/A N/A 21

23 Informal surveys indicate that Plans either contemplate or have allocations to EMs Some of these allocations part of SAA. Others use EM local bond opportunistically by broadening the fixed income mandate and then measure returns vs a hedged fixed income index. Many investors surveyed quote search for yield as important component in their decision to move into asset class. 22

24 How do foreign investors access local emerging bond markets

25 Accessing local sovereign debt markets Investors can access local emerging sovereign in mainly three ways: Through managers o o o Many institutional with smaller AUM (often below $20 bn) do not manage assets inhouse but rather hire external managers to manage the assets for them. Even institutions with larger asset bases may decide to hire external managers if the allocation is relatively small and/or it is difficult to hire talent to manage assets inhouse. Institutions then typically hire managers (either long-only or hedge fund managers). If they hire long-only managers they will decide against which benchmark the assets will be managed and whether the manager is supposed to just replicate the index (passive mandate) or aims to achieve an excess return vs the index through active management Through internal management o Institution may decide to manage assets in-house. Even in such case, in-house managers typically will be given a benchmark and they will either be asked to replicate the index or allowed to take positions away from the index within a certain risk budget to achieve excess returns. 24

26 Accessing local sovereign debt markets Investors can access local emerging sovereign in mainly three ways: Through ETFs o In 2011, Blackrock created an ETF that aims to replicate the Barclays EM index. o The AUM of the ETF now amounts to $35bn. 25

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