Local currency corporate bonds, a new star – Ashmore’s Dehn says

Jan Dehn, Head of Research at Ashmore, discusses why he thinks local currency corporate bonds will become a star in the EM fixed income sky and how they will allow investors to capture the upside from rapid structural change.

Of course, the USD 5.8trn market has been around for much longer, but it was only last week that Bank of America Merrill Lynch (BAML) formally launched the world’s first index for this asset class. Whilst the BAML index is imperfect – it only represents 5% of the universe of local currency corporate debt – its existence enables investors to tap into what could eventually become a USD 30trn asset class. Meanwhile, Europe produced the lowest inflation print in Eurostat’s history; we discuss why inflation is so low in Europe and what this means for the Euro over the medium term

One fundamental attraction of Emerging Markets is that both economies and asset classes evolve so rapidly. Ten years ago Brazil barely had a fixed coupon local currency sovereign bond market, today it is one of the largest and most liquid local markets in the EM universe. Five years ago African countries largely depended on donor financing with few accessing the markets; now 20% of the 60 countries in JP Morgan EMBI GD index are African. Last week Bank of America Merrill Lynch (BAML) launched the world’s first Emerging Markets local currency corporate bond index.

Index development is important: the vast majority of the world’s institutional investors only recognise asset classes if they have indices. Indices are used as a basis for comparing the relative performance of managers, measuring risk, etc. Excessive reliance on benchmarks for such purposes can be dangerous due to the inefficiency of the EM asset class and the vast ocean of off-benchmark opportunities. But we firmly believe that indices are desirable, because they constitute a key part of any market’s infrastructure.

Local currency corporate bond indices have been long in coming. Indices are public goods, whose benefits tend to accrue far more widely than the index provider itself. The inability of the index provider to capture all the benefits means that indices tend to be under-provided. The economic crisis, regulatory pressures, and bank specific issues have exacerbated this market failure. While the EM fixed income universe has continued to expand, indices have progressively become less and less representative of this universe.

BAML’s new family of local currency corporate bond indices breaks this trend. It is the first major development in the world of EM fixed income indices for a long time, and breaks open a whole new asset class. BAML’s initiative should therefore be applauded.

However, despite their enormous symbolic significance, BAML’s indices are still severely limited in scope. Their most important limitation is that they only cover Euroclearable securities, which probably reflects the difficulty of the provider to cover the costs of collecting data. The exclusion of non-Euroclearable securities whittles the universe of index-eligible bonds down to just USD 264bn, or 5% of the total universe of EM local currency
corporate debt USD 5.8trn.

BAML produces four different versions of the index: with / without issuer caps and with / without Sukuk bonds. There are also bond size restrictions, which further reduces the size of index eligible securities. The broad version that excludes bonds below USD 75m produces a universe of USD 168bn, and if stricter size limitations are applied (excluding bonds below USD 150m in size) the universe is reduced to USD 142bn. Exclude Sukuks and the universe shrinks to just USD 118bn.

Russia will move to Euroclearable local currency corporate bonds in early 2014. We believe other countries are likely to follow suit. The BAML local currency corporate bond indices offer a brand new type of risk to investors.

They are fundamentally different from Dollar corporate indices. More than half the names in the BAML indices are companies that do not feature in BAML’s external corporate bond indices, and only a quarter of the companies in the external indices feature in the local indices. The indices include non-rated securities, yet at BBB (for rated bonds) the average rating is high (similar to Dollar denominated corporate bond indices).


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