The search for higher returns has drawn international investors in droves to emerging market debt and to Latin American debt markets, specifically during the past few years. Data collected by EPFR Global show that money flows toward emerging market bond funds quadrupled from 2011 to 2012—a trend that remained strong through May 2013.
In Latin America, local currency bonds have become the main draw in recent years. Global investors are hunting for high-yield and high-quality bonds that provide room for currency and capital appreciation.
However, not all countries have received the same level of attention from foreign investors. Peru has by far the highest level of foreign participation, at 57 percent. Mexico’s local bond market is in second place, with a foreign participation rate of almost 40 percent, up from 15 percent following the financial crisis of 2008–2009. With almost $120 billion, Mexico represented the region’s largest absolute increase in foreign bond holdings in the past four years.
Mexico’s local market has also become a strong alternative to Brazil, where a 6 percent upfront entry tax on foreigners’ investments in fixed income securities had significantly slowed down foreign inflows into the domestic market since 2010.
The largest bond market in the region, Brazil, currently has less than 15 percent foreign ownership in the local bond market, but this is likely to change dramatically on the heels of the June 4 removal of the entry tax. Government bonds in Brazil currently yield about twice as much as Mexican government bonds, and foreign investors are expected to rediscover Brazil’s local currency bond market.
Other markets, such as Chile and Colombia, have figured lower on foreign investors’ targets; both have less than 10 percent of foreign investors in local bond markets.
But even hard currency bonds with historically low spreads have not been shunned by investors. The corporate issuance pipeline, in particular, has been well-received this year, and many recent bond issues have attracted demand that far exceeded supply. Sovereign issuers have rarely been able to issue debt at more favorable conditions, which has often left fiscal accounts much stronger than in developed markets. This has often reinforced a virtuous debt cycle, with the share of investment-grade countries in the region never having been this high.
Critics argue that the region was just in the right place, with ultra-low yields in developed markets—a function of monetary policy easing—pushing investors into Latin American bond markets. Still, global financial markets have recently worried about the tapering of the Federal Reserve Bank’s bond-buying program (quantitative easing) and the eventual end of abundant liquidity provisions.
Moreover, commodity prices have been losing momentum due to slower growth in China. Less Chinese commodity demand from Latin America could mean lower growth and weaker currencies in the region. Already, emerging market bonds—in local and hard currency—have experienced significant selloffs and there have been material outflows.
Does this mean the end of the success story in Latin American bond markets? Not quite.
The success of the region’s investment-grade countries in attracting international investors
is more than just coincidence:
it’s a success story shaped by more than a decade of hard work.
Starting in the mid-1990s, policymakers across Latin America set the foundation for today’s success. They improved balance sheets and implemented policies that turned a region prone to frequent debt and currency crises into a beacon of macroeconomic stability. Brazil, Mexico, Chile, Colombia, Peru, and others adopted policies that focused on inflation-targeting, fiscal responsibility and relatively free-floating currencies.
Better public debt management (longer average maturities and increased reliance on local debt issuance) also helped reduce vulnerability from external shocks and foreign exchange swings.
Just as important, structural shifts in the ownership of Latin American debt have helped increase the resilience of local bond markets. The shift in ownership among resident holders of domestic bonds shows a clear trend toward stronger participation of institutional money managers such as pension funds, mutual funds and insurance companies, and away from public-sector and bank holdings. This has had a stabilizing effect.
Will investors exit regional markets again? Unlikely.
First, the withdrawal of stimulus in the U.S. and elsewhere is not expected to be abrupt. Rather than ending easy monetary policy, what is being discussed is a future reduction in the amount of policy stimulus. Other countries are also still accommodating: the Bank of Japan’s recent decision to start a massive easing program may bring significant flows from Japan to Latin American bond markets.
Second, Latin American yields should adjust to preserve the relative yield advantage. Third, a tightening in global liquidity conditions will likely follow higher growth in developed markets, and this will translate into higher growth in the region, reducing the risk premium of emerging market bonds. Finally, foreign ownership is unevenly distributed. Likely structural reforms mean the country with the highest absolute foreign participation, Mexico, is expected to further reduce its yield spread vis-à-vis U.S. rates.
A close look at these trends suggests that global liquidity conditions will tighten only gradually over a relatively prolonged period. Recent market moves have added value. Markets like Brazil and Mexico will continue to attract investors, even with higher interest rates in developed markets. The bottom line: Latin American debt has been a success story that goes beyond the easing of monetary policy conditions in developed markets.