It is not surprising that the world’s bond markets have looked less and less appealing since their role in the financial crisis and their performance subsequent to it. What is more, experts predict that there is not likely to be much pick up in developed markets this year, or at least in the first half of it.
In 2010 bonds lost some of their attraction as a safe option. The European bond market in particular is heading for another turbulent year in 2011, with investors groping for direction in the face of an uncertain US recovery and a stubborn debt crisis in the eurozone. Sovereign bonds issued by eurozone members had a rough ride as a result of the debt and deficit debacle in Greece and huge financial pressures on the Irish banking sector. Both countries were eventually bailed out by the EU and the IMF. German and French bonds were the exception, with their yields falling to their lowest levels as investors who feared for the fate of the US economy saw such assets as a refuge.
The criticism of the EU’s poor handling and slow response to the Greek crisis rattled the market further, especially as banks held massive amounts of debt bonds issued by Portugal, Ireland, Greece, and Spain – financially weak countries on what became known as the eurozone’s ‘periphery.’ Eurozone officials moved faster in response to the Irish banking crisis, determined to shield Portugal and Spain from having to be rescued with outside money.
But even with the help of the European Central Bank, which since May has been trying to stabilise the market by buying bonds issued by periphery countries, the eurozone’s financial difficulties are likely to persist.
In particular, investors are looking closely at Spain’s long-term borrowing operations as the country could find itself unable to finance its debt on the market. Spain’s economy ranks fourth in the eurozone and a rescue would be far bigger than anything seen to date in Europe. The size of its economy is twice that of Greece, Ireland and Portugal combined.
Several solutions have been put forward, notably the creation of a permanent, well-endowed rescue fund – already approved in principle at an EU summit – and the launch of joint eurozone bonds, which would increase the chance of financially weak countries finding buyers for their debt. There is likely to be debate as well on whether governments should pursue growth or austerity as a means of securing stability and whether the ECB should step up its bond-buying programme.
The EU has already begun the first part of its euro rescue operation. In January it launched a multibillion-euro triple-A rated bond to raise money for the effort to rescue Ireland’s finances, in this year’s first important test of investor sentiment for Europe’s troubled government debt markets. Bankers say that there was strong demand for the bonds from European, Asian and Middle Eastern investors, even before the official opening of order books.
The EU sold about €5bn ($6.7bn) in five-year debt, the first part of some €50bn in bonds that will go towards the Irish bailout over the next two years. Strategists hope the auction will ease tensions in the eurozone bond markets, amid worries that this could be one of the most difficult starts to a year for the European government bond markets.
At the same time, investors fear that the auction could pose problems for some eurozone governments as fund managers opt to buy the EU debt instead of bonds of countries such as Portugal and Spain.
The euro bond, issued by the European Financial Stabilisation Mechanism on behalf of the EU, is underwritten by Barclays Capital, BNP Paribas, Deutsche Bank and HSBC. A further €5bn was due to be issued by the European Financial Stability Facility (EFSF) on behalf of the 17 eurozone members towards the end of January as World Finance was going to print, which would also go towards the Irish bailout. The European Commission has said that as much as €34.1bn will be raised for Ireland in 2011 and €14.9bn by Europe’s two financial aid funds.
The EU has been issuing bonds since the end of December 2008 when it launched its first bond since 1993 to help fund a loan package for Hungary. It launched another bond in February 2009 to support an assistance programme for Latvia. The EFSF bond is seen as a landmark for Europe’s markets as it will be the first issued by the eurozone as one entity. Some investors say it could be the first step towards a common eurozone bond, which may excite the market, particularly as some EU governments are cancelling their own bond sales. For example, Austria has cancelled a bond auction scheduled for January, opting to issue debt through a syndicated deal instead. Some bankers suggested this highlighted the pressures for eurozone governments as syndications are often used to issue bonds that are difficult to sell.
While the current appetite for bonds in the European market may be subdued, investor interest has moved towards emerging markets, particularly Latin America. Barclays Capital has launched a new emerging market local currency bond index. The Markets Tradable Local Currency Bond Index is composed of debt from about 16 emerging market nations and is a rules-based tradable subset of the flagship Barclays’ local currency government benchmark index.
The portfolio is rebalanced semi-annually and includes representative and liquid benchmark-eligible bonds from four different regions – Latin America, Eastern Europe, Middle East and Africa, and Asia. The index is the latest addition to BarCap’s emerging markets index platform, which includes benchmark bond indices, tradable bond indices, FX indices, equity indices, and interest rate swaps indices.
Also, at the start of the year Acadian Asset Management, which has $48bn in assets under management, announced the launch of its emerging markets debt fund, tapping a developing world its manager believes presents long-term investment opportunities. The Acadian Emerging Markets Debt Fund, trading under AEMDX, is starting off with just over $10m under management. John Peta, whose group oversees $30m in emerging market debt, said the improving fundamentals and convergence of sovereign credit ratings between the developing and advanced economies will offer further upside in emerging markets debt. In particular, Mr Peta likes Brazil and Peru which are benefiting from strong domestic demand and exports to China. “If you were somebody from Mars and looked down at these countries and forget their names, looking at just the characteristics, often times, emerging countries look a lot better,” Mr Peta says.
His views have been echoed by Bill Gross, the manager of the world’s biggest bond fund, Pacific Investment Management. In 2010 he urged investors to buy emerging market bonds to protect themselves from “mindless” US deficit spending and its inflationary consequences. Rising inflation reduces the real returns offered by fixed income investments.
Over the past 10 years, sovereign credit ratings have narrowed between developed and developing markets, says Mr Peta, with the convergence happening from both ends. The emerging markets that were often associated with high risk of default are now predominately investment grade, while established countries such as Italy, Greece and Ireland have suffered downgrades.
Last year, funds focused on developing-nation debt made handsome returns, with many portfolio managers anticipating more in the coming year. The T. Rowe Price Emerging Markets Bond fund posted 12.95 percent returns in the past year. Its manager, Michael Conelius, believes that six percent plus returns are likely this year, citing improving credit quality among the emerging markets. Others such as the Payden Emerging Market Bond fund and PIMCO Emerging Market Bond A Load, each posted more than 12 percent in returns last year.
“The debt dynamics in emerging markets have always been equal or better on average than developed markets,” Mr Peta says. “People don’t realise that, still thinking emerging market countries are a basket case.”
Yet it isn’t just foreign investors who are getting excited about Latin America’s potential: some of the region’s own companies want to enjoy a piece of the action. Several Brazilian companies have moved or plan to tap overseas debt markets to take advantage of a hunger for assets in the South American country. In January the government-controlled Banco do Brasil SA, Latin America’s largest bank by assets, raised €750m by issuing eurobonds, paying an annual yield of 4.625 percent. Demand for the issue reached €1.4bn, underlining the strong interest in Brazilian assets, which analysts attribute to a recovery in commodity prices and the resilience of the Brazilian economy during the global financial crisis.
Brazil’s economy fell into a recession in 2009 on the heels of the global credit crisis, with GDP shrinking 0.6 percent. But 2010 saw a robust recovery, aided by ample government and private credit and a series of tax cuts aimed at encouraging consumption. GDP is expected to have risen by more than 7.5 percent last year. For this year, the country’s economy is likely to post a 4.5 percent expansion, which is fuelling investor appetite and local companies’ willingness to raise cash.
Since the start of 2011, Brazil’s largest shopping centre operator, BR Malls Participacoes SA, raised $230m by issuing overseas perpetual bonds. Also, medium-sized bank Banco Cruzeiro do Sul SA priced a five-year bond worth $400m, offering a yield of 8.375 percent. Other local companies have also issued debt.
And Latin America is not the only emerging economy that is toying with exploring foreign debt markets to raise cash. Union Bank of India has started meeting investors in order to raise at least SWF125m ($128.5m) in its first sale of debt, denominated in the European nation’s currency. The Mumbai-based bank is selling 3.25 per cent, 4.5-year bonds. Union Bank officials met investors in Zurich, Geneva, Lausanne and Vaduz during November. The bank’s general manager VK Khanna believes that markets in Switzerland are stable and there’s still appetite for emerging-market bonds.
Union Bank is selling Swiss franc bonds to reduce costs and expand its investor base, pricing the notes to yield 200 basis points more than the swap rate. Barclays is helping sell the debt. The bonds mature on July 8, 2015. Indian companies more than tripled the sale of foreign-currency bonds to $8.7bn in 2010 as the central bank drove up rupee borrowing costs with six interest-rate increases. This compares to record sales of $9.3bn in 2007.
But not all emerging markets are benefiting from investor appetite. Some are seeing cash move out of the country, rather than flow in. For example, foreign investors sold a net R23.4bn worth of South African bonds between October and December last year, after net inflows of R75.3bn in the previous nine months, according to the Reserve Bank. Jeff Gable at Absa Capital said that investments in emerging market bonds had slowed, but the reversal in flows was “South Africa specific.” One reason was “the market’s expectation that the November rate cut would be the last.” The central bank cut the repo rate 5.5 percent that month, from a peak of 12 percent in December 2008. “Investors… holding South African bonds during the period of rate cuts may have taken the opportunity to lock in some of the profits from earlier trades,” Mr Gable said. The value of bonds rises when rates fall.
Fund managers say that both longer-term investors and speculators had been investing in local bonds, and that the recent outflows represented profit taking by hedge funds and other speculative investors. In contrast to these hot flows, they say, investment by pension funds was more stable, with investor horizons of up to five years. In the year as a whole, local bonds attracted nearly R52bn in non-resident funds while only R36bn went into Johannesburg Stock Exchange-listed shares.
JP Morgan has estimated a record $75bn flowed into emerging market bonds with the bulk of the flows coming from longer-term investors. The bank also predicts that net inflows into fixed income instruments in emerging markets will stay between $70bn and $75bn this year.
Yet perhaps the biggest casualty of bond market volatility has been Islamic bonds. The UK, Europe’s largest market for Shariah-compliant financial products and services, has cancelled what would have been the first sale of sovereign Islamic bonds by a Western federal government as issues fell 15 percent in 2010. The UK government has decided not to issue sovereign sukuk because it is judged not to provide value for money, according to a spokesman at the Treasury. It says that the UK will “keep the situation under review.” The Treasury has been mulling the sale of Islamic bonds denominated in pounds since at least April 2007.
Growth in Europe’s Islamic financial hub has been hampered by slowing economic expansion and the government’s attempt to plug a budget deficit, according to Moody’s Investors Service. The German state of Saxony-Anhalt became the first European borrower to sell bonds adhering to Islamic law in August 2004 with €100m of five-year sukuk, while International Innovative Technologies Ltd, a clean energy company in Gateshead, sold a $10m, four-year convertible sukuk in July 2010, becoming the UK’s first corporate Islamic bond.
Despite the UK’s decision to dump the sales, some institutions are inclined to carry on. The Bank of London and the Middle East Plc, a Shariah-compliant bank, is in discussions with two UK-based companies to sell as much as £200m of Islamic bonds in the next six months.
But investment analysts say that the UK Treasury’s decision will discourage other governments from selling sukuk. “If the UK says that sukuk aren’t value for money, it’s likely other governments may reassess their positions, and the number of sovereign issuers new to Islamic finance may drop,” says John A Sandwick, a Geneva-based Islamic wealth and asset management consultant.
