by Paul Kilby

The surge of flows into EM local currency debt instruments in 2011 and the subsequent spike in international bond issues denominated in pesos and reais, particularly from corporates, has left bankers bullish on the prospects for this growing asset class.

But buyside attitudes toward this sector have arguably turned more ambivalent this year after FX volatility burned some investors and sparked a sudden reversal in flows at the end of 2011.

This hasn’t stopped bankers from plotting the next stage in the evolution of this market. While finding ways to broaden the menu of investment options and create more liquidity for this asset class are proving tricky, bankers ultimately hope such problems will be solved by breaking down some of the fiscal and regulatory barriers that have so often created bifurcated onshore and offshore markets.

Global local currency instruments and even the more recently created global depository notes (GDNs) are approaching the end of their useful life, argue some bankers who see such specialized instruments eventually becoming extinct as foreigners increasingly engage directly with local markets, much like what happened with ADRs in the equity space.

The ultimate aim is to have international and local investors buying into the same local currency-denominated corporate bond, and creating the liquidity so coveted by the buyside and the favorable pricing dynamics sought by borrowers.

In some ways, this melding of foreign and local investors is already starting to occur, but on an intra-regional basis, with bankers selling not only dollar bonds, but corporate global real bonds to Chilean investors, for instance.

This has further lent support to a market that last year saw what were arguably record volumes in cross-border corporate local currency trades, with Colombian companies for the first time issuing such instruments.

“Local currency has made a comeback,” says Chris Gilfond, co-head of LatAm credit markets for Citigroup. “We saw $8.6 billion in 2011, up from $7.5 billion in 2007. That doesn’t include cross-border transactions like Banco de Chile in Mexico.”

Despite the selloff last year, bankers reckon local currency instruments should remain a popular choice among investors seeking yield at a time when Fed Chairman Ben Bernanke has pledged to keep rates low into 2014.

The market may soon see infrastructure real-denominated debentures being sold to both Brazilians onshore and foreign investors offshore now that the government has eliminated the IOF tax that previously made such trades so unattractive.

First Corporate GDN

In Mexico, the first corporate global depositary note from Pemex was also designed to allow international accounts to participate in the country’s local corporate debt market. Already used by sovereigns such as Peru, GDNs are much like an ADR for the bond sector, bundling local currency instruments that can be interchanged for GDNs and vice-versa.

For foreign investors who don’t have the time or inclination to set up an on-the-ground custodian, GDNs are thought to be a convenient way of entering the local market. They are sold under a 144A/RegS format, settled through DTC, Euroclear and Clearstream, paid in US dollars linked to local currency and withholding tax is grossed up by the issuer.

“GDNs are the best mouse trap that allows the borrower to capture both international and local accounts,” says Charles Moser, an executive director at Morgan Stanley that acted as sole structuring agent and managed the sale in January, along with HSBC and Santander.

Moser sees the use of corporate GDNs spreading to other countries as well, including Chile, Peru, Brazil, Colombia, Panama and the Dominican Republic, though this will require banks to first work more closely with regulators. “Just as happened with the ADR, each country will have to get comfortable with convertibility exchange and the fiscal treatment of the instrument,” Moser adds.

Mexico was perhaps the best place to start, given it already has a fully convertible currency and a clear policy of creating one curve for both foreign and local investors alike. The quasi-sovereign Pemex was also seen as an ideal candidate given it already has a following in the domestic markets and an abundance of outstanding bonds there.

“This instrument opens doors for private companies and other public sector [issuers] to start convincing foreign investors to start participating,” says Juan Pablo Newman, Mexico’s director of debt issuance.

Eventually, some bankers see the market outgrowing GDNs, but for this to happen, more local securities will have to be cleared through Euroclear, and this means that Euroclear will have to work with local banks, getting comfortable with operational and trading risks involved, says Citigroup’s Gilfond.

“Over the next five to 10 years Euroclear will expand its capabilities as a custodian or hire a bank to hold, say certificados busatiles in Mexico,” he adds. “The local currency market will evolve in much the same way as the equity space did, where new issues no longer involve ADRs, but are simply local transactions.”

To bring both local and international investors under one roof may ultimately mean that countries will have to ease capital controls and taxes that discourage foreign accounts from participating in local markets.

“Governments would like to develop their corporate bond markets, but have to have fiscal reforms to do away with withholding taxes for foreigners. Let’s face it – this is a big issue for investors,” says Tim Goodell, head of emerging market debt sales at BBVA.

This may be a slow process, admits Goodell, especially during election years. Ultimately, governments will have to weigh the cost of the volatility that comes with increased capital flows and the advantages of accessing a larger market in their own currency.

“Is this incredible volatility sometimes driven by foreign investment flows into your local bond market? Absolutely,” says Goodell. “But if the government issues 40-year paper in their local currency and a huge chunk is taken up by foreign investors, is that such a bad thing?”

For now, however, foreign investors that wish to participate in the market, at least the ones that don’t have a local presence, will have to stick to the global local currency format, or in the case of Mexico, GDNs.

Liquidity Dilemma

However, investors are taking a more cautious approach to local currency markets in LatAm after showing considerable enthusiasm for the asset class, said Jim Barrineau, a senior portfolio manager at ICE Canyon, at a recent LatinFinance event.

Investment options remain limited in this arena, often resulting in crowded trades that can generate substantial selloffs during times of heightened risk aversion. “When pitched local currency, investors are [now] saying not so fast,” Barrineau adds, as the buyside learns that a market that has offered high returns can quickly reverse such gains.

Liquidity has been another concern. “This market is five to 10 times less liquid than other asset classes. It is therefore more volatile, and you are adding currency and rate risks,” says Polina Kurdyavko, senior portfolio manager at BlueBay Asset Management. “If you are increasing volatility, you need to make sure you are increasing liquidity as well.”

A local currency corporate index may go some way toward remedying this situation, says Robert Abad, a senior analyst at Western Asset Management, which has $37 billion under management in EM. “There is no local currency index, so no one will provide daily pricing on these corporates,” he says. “This is very important as a measure of liquidity.”

BlueBay has been working with a large bank on just this very idea, but finding a reliable daily pricing source has proven problematic, says Kurdyavko. “You can’t create an index if you don’t have liquidity in the bonds, but once you create it, it would bring more liquidity,” she adds.

Given the multi-layers of risks involved, local currency corporate bonds still remain a bull market trade. This may change as the asset class becomes more mainstream, but for now borrowers must choose their windows carefully.

Up to now, FX levels have played a major role in the appetite for such instruments. If the currency is recovering from recent lows as the Mexican peso was early this year, accounts are likely to be more inclined to participate.

“Timing has to be right,” says Katia Bouazza, co-head of global capital markets, Americas at HSBC. “It is not the kind of product that will achieve the liquidity you have with dollar benchmark bonds, but more and more we are designing it to be more flexible for investors, and more opportunistic for issuers so that they can achieve size and bring in a combination of local as well as international investors.” LF