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.
But the market’s liquidity and the trading skills and stamina of the market makers were never put to a greater test than they were this February. The Fed’s rate hike, hinting that the central bank knew something about impending U.S. inflation that investors didn’t, battered bond markets worldwide. The impact was especially devastating across the broad spectrum of the emerging-debt markets. “This sort of blows the diversification argument out of the water,” sighed one shaken trader. Among the worst-performing Bradys were Argentina’s par bonds, which tumbled 13.25 percent in the following weeks, and Venezuelan debt-conversion bonds, which fell 19.24 percent.
The sharp downturn was exacerbated by trade tensions between Washington and Tokyo, which fed rumors that Japanese banks would unload paper. Those were only partially borne out. Yet the prospect of a trade war did cause a sudden reversal in the widely held expectation that the yen would weaken.
Steep losses in the yen-dollar market then led several highly leveraged hedge funds and proprietary trading desks to unwind long positions in the emerging-debt market to offset the losses. And margin calls op investors that had leveraged their positions, but lacked the ready cash to meet the calls, compelled them to aggressively hit market makers’ bids to unwind their long positions, thus adding to the downward momentum.
“With so much bid hitting, quite a lot of people withdrew from the markets,” notes Marc Wenhammer, who heads Foreign & Colonial’s Emerging Markets Fund in London. This was especially true of the newer or smaller trading houses, which are likely to melt away altogether in a crisis, notes SBC’s Snell. But even the bigger, more established trading houses will often withdraw from trading or revert to client-only trading. That happened in this case, everywhere widening thin dealing spreads.
“All you could do to protect yourself under such conditions was to widen the bid-offer spread,” says Snell. Bid-offer spreads on Brady bonds widened to 0.5 and even 1 percent at times, only falling back to 0.5 percent in March; last year a quarter-point spread prevailed. Dealing spreads in the more illiquid loan paper, such as Ecuador’s, widened to as much as 6 percent, says one fund manager.
In mid-March many market participants felt the market correction had yet to touch bottom. Even those daring enough to bottom fish found it hard to execute switches among bonds because of the volatility in prices. Most investors stuck to the sidelines despite the staggering yields that were once again available: Argentinean par bonds, for instance, were yielding 11.25 percent in mid-March. But as one Paris-based investor observed, “Why buy [a bond] if you could lose your higher income in one afternoon with another price fall?”
Dominant banks
Yet even though investors have taken a beating, the market remains intact. Fidelity Investment Advisers’ Robert Citrone is among the many fund managers who emphasize that, however much dealing spreads may have widened, the big market makers - J.P. Morgan, Salomon, Chemical, Citibank, Merrill Lynch - continued making two-way quotes, maintaining liquidity. Market makers, battered though they may be by inventory losses, argue that this sort of commitment will in time vindicate the market and ensure the eventual return of institutional investors.
The upheavals of February and March will undoubtedly add to the profound impact that the coming of age the emerging-debt markets is having on banks, market makers and underwriters. Shelf registration in the U.S., the bought deal in the Eurobond market and the integration of derivatives all reshuffled the pecking order among banks - and realigned desks and careers. Now a similar phenomenon is occurring among those dealing in emerging-markets debt. Firms that manage the process best are likely to emerge dominant.
Prodded by institutional investors, bank’s have been adding a variety of services to their emerging-markets trading desks in London, New York, Switzerland and Asia as well as in the Latin American capitals. The list is extensive: technical and macroeconomic research, market analysis, sales and distribution teams, over-the-counter derivatives products, origination and syndicate teams, swap and option traders, spot and arbitrage traders. Some houses are integrating their emerging-markets desks into their global capital markets and treasury departments.
Significantly, bankers who came up on the emerging-markets side, such as Chase Manhattan Bank’s Kathy O’Donnell. now run their bank’s overall global markets operations. Peter Geraghty, ING Bank’s former head of emerging-markets debt trading in New York, was recently elevated to head of international capital markets and treasury operations.
This rapid expansion comes at a hefty cost, but it seemed worth it last year. Houses well established in the market report returns of 25 to 50 percent on capital. Some boast of profits well in excess of 100 percent. J.P. Morgan chairman Dennis Weatherstone singled out trading in emerging-markets debt as a “key contributing factor” to the bank’s $1.56 billion net income last year. Morgan’s hit on emerging-markets trading earlier this year - market gossip put the loss in the $100 million range - will hurt, but by no means erase, the desk’s profits in ’94.
Although the Emerging Market Traders Association now has more than 125 members, the market continues to be dominated by a half dozen full-service market makers. J.P. Morgan and Salomon tower over the others in both the sheer range of bonds they trade and the scope of the services they offer, research especially. Of the other leaders, Chemical, Citibank and Chase Manhattan are big flow traders, while Morgan Grenfell does a high volume of flow trading as well as arbitrage.
Dominant houses got their edge by melding their capital markets activities with their emerging-markets debt trading desks as early as late 1990. In expanding their capabilities, probably the most important function was distribution. “In terms of distribution, you need to be in the top three or you ought to be worried,” asserts J.P. Morgan’s Rohatyn.
The bigger houses handle a trading volume of $300 million to $1 billion a day. The average, estimates Salomon’s Masco, is $600 million. Volume can soar well beyond those levels. In the fortnight leading up to the Nafta vote, volume reached $1.2 billion a day at Salomon, and Chemical says it turned over $3 billion on some days. And in the last few days of February this year, daily turnover soared even higher.
Nearly all the houses run both a front and a back book. The former comprises now trading, in which profits are made on high turnover and bid-offer spreads. The back book, the house account, is mainly for trading loan paper and betting on market direction. ING, Morgan Stanley & Co., Bankers Trust Co. and Goldman, Sachs & Co. are believed to run the largest proprietary trading books.
Clients only
Distinct strategies are starting to surface. Several houses, notably ING, Merrill Lynch and Banque Indosuez, have stopped market making to the Street. They now restrict their trading to clients and to their own portfolios. “We looked at where we were making the most money and concluded it was best to stick with those two. trading for our client base and our proprietary trading,” explains Willem Naves, who heads ING’s emerging-markets group in London. “Let’s face it, there are plenty of live screens to see the flows anyway.”
Market makers, however, dismiss the move as defensive. Salomon’s Masco argues that market making allows a firm to see the flows and the market direction, enabling it to get the best prices for its clients. Citibank’s head of emerging-markets debt trading, Frederico Carballo, adds that positioning opportunities will steadily diminish as more houses and investors scour the market. Thus, he says, banks will have to rely on flow trading for a greater share of their profits. “Market making will become more important and positioning much less so in the years ahead,” he predicts.
The differing approaches - influenced, naturally, by firms’ competitive edges - have lead to tiering among banks. A handful, such as Bear, Stearns & Co., CS First Boston and Lehman Brothers, as well as more recent entrants like Nomura Securities International and Union Bank of Switzerland, aim to be full-service market makers. But most others have preferred to build solid reputations around profitable niches. Standard Chartered Bank has found a home in trading money market instruments, while Continental Bank specializes in trading East European and Russian debt. Other houses, such as Banque Paribas and SBC, played to their strength in the Eurobond market and retail placement by expanding beyond secondary trading to new-issue underwriting.
Paribas, Bankers Trust, J.P. Morgan, Swiss Bank and Merrill have led a charge into OTC derivatives and structured products. Paribas’s Shahida notes, the growth in the cash market has triggered an enormous demand for derivatives in emerging-markets debt, either to leverage an investment or to protect profits. The volume of OTC debt options grew to about a quarter that of the cash market last year, deepening liquidity, notes Varun Gosain, head of OTC options trading at Banque Paribas in New York.
Force or fad?
Despite the massive hits many market makers have taken so far this year, and despite the concern over the extent to which other investors will return to the market, all but a handful of smaller houses remain firmly committed to the emerging-debt markets. J.P. Morgan’s Rohatyn confidently predicts that foreign investors will venture more aggressively into emerging countries’ domestic money and bond markets, fueling renewed growth.
Yet the psychological scars of the 87 crash, the collapse of the floating-rate-note market that same year and the junk bond market debacle in 1990 run deep. Every new market with high returns and rapid growth is immediately branded the next crisis waiting to happen. What derivatives were to the doomsayers in 1991-1992, emerging markets are this year.
Could emerging markets, with all their potential to become “the capital market to the rest of the world,” in Rohatyn’s phrase, somehow go disastrously wrong? A continued escalation of U.S. interest rates might send emerging markets crashing still further, but bond markets worldwide would be bashed as well. What about a collapse confined to emerging markets? That would “depend on whether you believe these countries will all tank out or not,” reasons Salomon’s Purcell. “Some might, but most won’t. I still believe in the credit stories. And if I didn’t believe these things were truly emerging. I wouldn’t be betting my career on it.”
A lot of profits, and other careers, ride on his being right.
