In this edition of From the Archive, we take you back to
April 1994, as Institutional Investor Senior
Correspondent Kevin Muehring explores the ever-evolving
investment strategy that is emerging-markets debt.
Emerging-markets Debt Comes of Age
By Kevin Muehring
"This is emerging-markets debt trading, not LDC debt
trading," chides Susan Segal. The head of Chemical Bank's
emerging-markets division in New York, she is correcting a
visitor's casual characterization of what she does for a
The semantic distinction is symbolically important. To Segal
and her peers, who trade the debt of what used to be called the
less developed countries, "LDC" conjures up images of all those
dud loans that touched off the debt crisis, and blighted
banking careers, after Mexico's default in August 1982.
"Emerging markets," by contrast, has the happy ring of solid
coin, connoting fast-improving economies, dazzling profits and
certain career advancement. In 1993 emerging-markets prices
rose to gravity-defying levels, and trading volume doubled, to
$1.5 trillion or more. Dozens of commercial, investment and
universal banks responded to the surging market by pumping more
capital and credit lines into their emerging-markets operations
and building up their trading desks, transforming them into
fully integrated capital markets operations to rival their
Then came the rout of bond markets worldwide, but especially
those of emerging countries, in the wake of the Federal Reserve
Board's nudging of the federal funds rate on February 4.
The damage to emerging-debt markets, while undeniable, is
not likely to be lasting, however. "The growth in the market
reflects the fundamental political and economic changes taking
place in the world today," argues Nicolas Rohatyn, head of
emerging-markets sales, trading and research at J.P. Morgan
& Co. "We are moving from a world of seven currencies and
interest rates to one of 47 currencies and interest rates. And
despite the recent correction, that basic trend is
Massive inflows of institutional money, particularly from
yield-hungry U.S. investors, have transformed the market in
just the past two years from a sideshow to the Eurobond market
to a major market in its own right. "Global investors
legitimized the emerging markets," says Chemical's Segal.
At one time the relevant investor base consisted of
Miami-based Latin flight capital, hit-and-run hedge funds, a
handful of early dedicated-country funds and the "original
holder" banks that created much of the supply of debt by
securitizing defaulted loans. But these players made way for
scores of mostly U.S.-based mutual funds, junk bond funds and
even insurance companies and pension funds lured by the
emerging-debt markets' high yields, solid spread performance
and capital gains. By the end of last year, such mainstream
institutions held as much as 30 percent, or $172 billion, of
the $425 billion in outstanding emerging-markets debt,
estimates John Purcell, Salomon Brothers' head of
Those who jumped in early enough were richly rewarded last
year. The top performers among fixed-income mutual funds were
chock-full of emerging-markets debt. Morgan Grenfell &
Co.'s Latin American Brady Fund generated a 94.6 percent
return. (It's all the more impressive considering that the fund
was unwound and the profits distributed at the end of the
year.) Chemical Bank's total-returns index increased 53.3
percent, while J.P. Morgan's Brady Bond index produced a 44.2
percent return. Compare that with the U.S. bond market's 10.1
percent, or the Salomon World Government Bond index's 13.3
percent, or even the 17.3 percent gain on U.S. junk bonds.
Emerging-markets returns would have been even more dazzling
had the portfolios included a smattering of volatile impaired
debt. "The people who made a lot of money last year were those
with exposure to the illiquid loans," says Shahriar Shahida,
who heads the emerging-markets desk at Banque Paribas. He cites
Sudan, whose debt rose during 1993 from a penny on the dollar
to 7 cents; Cuba, from 9 to 25 cents; Nicaragua, from 8 to 16
cents; and Morocco, from 30 to 70 cents.
Another play last year was buying into the impaired debt of
countries primed to negotiate a Brady deal. On just such an
expectation, Peru's impaired debt rose nearly 240 percent in
1993, from 20 cents on the dollar to 67 cents.
Encouraged by such stellar returns, most investors and
trading houses went into the new year with very long positions
- and some with highly leveraged long positions. But a few of
the savvier investors, such as Los Angeles-based Trust Co. of
the West, became wary of the markets' topping out and began
moving into cash in December.
"You didn't have to have a lot of brains to see the market
got way, way overbought," says TCW's Gerard Finneran. TCW, he
adds, was "very liquid" going into the new year and was very
liquid by March, when it began buying some paper at the higher
But most other investors were out to lunch, an expensive one
as it turns out. Unless they had already taken profits,
investors gave up some of their gains - sometimes in big chunks
- in the first quarter, mostly in just the last half of
February. J.P. Morgan's Emerging Market Brady index, for
instance, had sunk by 10.59 percent in the year to mid-March. A
broader index that includes restructured loans as well as Brady
bonds and is compiled by the London-based West Merchant Bank
fell nearly 14 percent in the first quarter.
Fixed-rate paper was hit the worst, falling on average by
13.37 percent in the year to mid-March, according to J.P.
Morgan figures, while floating-rate paper fell a less severe
7.68 percent. The collapse of loan paper was the most
precipitous. Citibank Peruvian loan paper fell 8 percent in a
single day, February 25.
Big Four issuers
As of last year emerging-markets debt outstanding broke down
this way, according to Salomon Brothers: about $80 billion in
Brady bonds; $254 billion in medium- and short-term bank debt,
including pre-Brady bank debt; and about $91 billion in
Eurobonds, globals and Yankee bonds. In addition, there is $272
billion in local-currency, domestic-market instruments, some of
which foreign investors can't buy.
Most of the paper is sovereign debt. Although the market had
been rapidly expanding to include issues from Asia and Eastern
Europe, the debt outstanding and the turnover are
overwhelmingly Latin. The market's Big Four issuers - Mexico,
Argentina, Venezuela and Brazil - account for nearly 60 percent
of both bonds and loan paper.
Brady bonds, which tend to be the first choice for
emerging-markets asset allocation, are easily the most liquid.
Dealing spreads on the most liquid of all Bradys were
compressed down to a quarter point on round lots of at least
$25 million last year. The big market makers, such as Salomon,
J.P. Morgan and Chemical, were known on occasion to trade S50
million or even $100 million on a single quote for a good
client. "A good institutional client could certainly lift $100
million with two or three calls," says Paul Masco, Salomon's
head emerging-markets trader in New York.
Such liquidity compares favorably with that of the U.S.
corporate bond and Eurobond markets. There dealing spreads tend
to be one quarter to one half of 1 percent, and round lots are
never more than $5 million. The most actively traded
international bond in the Euroclear system last year, by a
factor of three, was the Republic of Argentina par Series L
bond. Many investors consider the Mexican par bond something of
a benchmark. "The Mexican par bond market is one of the most
liquid markets in the world after the U.S. Treasury market,"
says Howard Snell, director of emerging-markets trading and
finance at Swiss Bank Corp. in London.
Liquidity is prized in the volatile emerging markets because
investors and market makers often need to lay off large
positions quickly. During the course of 1993, for instance,
Venezuelan debt-conversion bonds swung from 60 to 48 to 74
cents. "Serious mistakes could have been made in Venezuela
because it was so volatile in 1993," says Paribas's Shahida,
adding with a shrug that "it was pretty volatile in 1992 as
well." That year the country endured two coup attempts.
Even Mexican Bradys got whipsawed in the fortnight before
the U.S. Congress voted on the North American Free Trade
Agreement. Many institutions that had been buying into Mexico
stepped to the sidelines, leading to a dearth of buy orders to
offset bonds being sold back to market makers. The market
makers, in turn, found it hard to lay off positions, and many
tried to run off inventories or go short in anticipation of a
At one point, when it looked as though President Bill
Clinton wouldn't get the necessary votes to pass the treaty,
the Mexican pars spiked downward by 7 cents, to 75 cents, and
their spread over the U.S. long bond widened to as much as 265
basis points from 225. But after Vice President Al Gore Jr.
routed H. Ross Perot in their famous Nafta debate, the pars
bounced back to 82 cents and the spread tightened to 180 basis
"It was a very scary period," recalls Chemical's head debt
trader, Alexis Rodzianko. "A lot of people were running scared
when it looked like [the bill] might not go through. We were
getting calls from customers to |take any bid if Nafta
Trading in impaired-loan debt can be wilder yet. In April of
last year Grenfell's chief emerging-markets strategist, Paul
Luke, made a great call to buy some of the $23 billion in debt
that Russia's Vneshekonombank owes to the London Club banks. It
was then trading at about 15 cents, but rose to a peak of 55.
cents in December before plunging to 43 after Russia's
parliamentary elections. After falling further, to 33 cents, it
had edged back to 35 by early February.