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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.

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Emerging-markets Debt Comes of Age
By Kevin Muehring

Institutional Investor
April 1994

"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 living.

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 developed-markets desks.

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 irreversible."

Yield-hungry

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 emerging-markets research.

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 yields.

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 Nafta defeat.

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 points.

"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 fails."

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.

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