Spreads narrow, then widen

Secondary market spreads on developing country bonds narrowed markedly from early 1995 through the first half of 1997, raising concerns that such extremely narrow spreads were not sustainable. A reappraisal of the risks of emerging markets induced a sharp reversal in secondary market spreads in the second half of 1997.

The decline in spreads

Secondary market spreads fell dramatically from early 1995 to mid-1997. The yield spread (against U.S. Treasuries of comparable final maturity and coupon) on Brady bonds fell from almost 1,600 basis points in early 1995 to 350 basis points in September 1997 (figure 1.2). More broadly, secondary market spreads on sovereign eurobonds declined in Southeast Asia until the onset of the currency crisis in July and fell in Latin America and in European developing countries through September 1997 (figure 1.3). Spreads declined on primary issues as well, though not by as much, with the average spread on new international bond issues to developing countries falling from 355 basis points in 1994 to 258 basis points in the first eight months of 1997. 2/

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Several developments contributed to the decline in secondary market spreads. Among Latin American borrowers in particular, the decline was in part a response to the recovery from the extremely high levels reached during the Mexican peso crisis, when an index of the spreads on Brady bonds reached the highest point seen since December 1990, the first period for which it was calculated. Liquid international markets, low rates of inflation, and sustained economic growth in industrial countries helped narrow spreads by reducing uncertainty and encouraging a decline in risk-free interest rates. This increased competitive pressures on lenders to seek out higher-yielding, more risky assets, thus reducing spreads on such assets in both developing and industrial countries. For example, spreads on low-grade U.S. corporate bonds, as represented by the Merrill Lynch high-yield index, have fallen from more than 400 basis points to around 300 basis over the past two years (see figure 1.2). 3/

Investors appeared to view industrial and developing country bonds of comparable rating as increasingly substitutable assets, giving further impetus to the decline in spreads in emerging markets. The spreads facing some borrowers declined in response to improvements in credit ratings. And greater use of developing country instruments increased their liquidity, thus reducing margins. For example, trading of a sample of emerging market benchmark bonds rose from about 2 million transactions in 1993 to 5.3 million transactions in 1996 (Emerging Markets Traders Association).

It is difficult to measure just how much each of these factors contributed to the fall in spreads. One study attributes much of the decline in spreads from 1995 to early 1997 to a shift in market sentiment toward a greater acceptance of developing country debt, rather than to improvements in creditworthiness or increases in international liquidity (as evidenced by falling rates of U.S. Treasuries; Eichengreen and Mody 1998). Another study of the decline in spreads from the second quarter of 1995 to the third quarter of 1997 found more than half of it to be attributable to the increased global supply of capital rather than to improved economic fundamentals in borrowing countries (Cline and Barnes 1997).

The rise in spreads

Secondary market spreads increased dramatically in late 1997, as the average spread on Brady bonds jumped from 350 basis points in September to more than 600 basis points in early November (see figure 1.2). Countries in all regions were affected. Spreads reached very high levels in East Asian countries. For example, spreads in Thailand, which had risen from 88 basis points in June to 187 basis points in mid-October, leaped past 400 basis points by mid-November (figure 1.4). Spreads for major Latin American borrowers also increased. Secondary market spreads on eurobonds issued by Brazil (which was also a target of speculative pressures against the exchange rate) jumped dramatically, from 151 basis points in mid-October to 541 basis points in mid-November. By the end of December, however, there were signs that investors were differentiating more carefully among developing country borrowers. Spreads for Argentina and Brazil, which had reached the highest levels in Latin America, fell by 100 and 250 basis points from their November peaks, and spreads for Mexico, which had risen less, eased slightly. By contrast, spreads for Southeast Asia registered further increases, with Indonesia’s spread up more than 150 basis points from November.

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The increase in secondary market spreads led to a pronounced contraction in bond market activity. Developing country borrowers were reluctant to issue new bonds at these higher rates, preferring to defer borrowing until market conditions became more settled. Argentina issued the only sovereign eurobond during the last two months of the year. Some borrowers were able to tap the loan market late in the year, however, some through securitized loans.

The risk reappraisal that set off the widespread increase in spreads may reflect both a reevaluation of economic fundamentals in some countries and a correction to what has come to be viewed as market overshooting earlier in the year. Just as asset prices may exhibit excess volatility (volatility beyond that justified by fundamentals; see Shiller 1989), there may be excess volatility in spreads. Low spreads will lead borrowers to increase their exposure and encourage lenders to be too optimistic in their assessments of risk, thus leading to high volumes of flows. This overshooting of markets, inducing excessive borrowing, implies a reversal of flows when market volatility (and thus uncertainty) increases. This cycle of declining spreads and rising borrowing followed by sharp reversals may be accentuated by acute competition among fund managers, as they strive to increase yields when spreads decline and stage a general withdrawal to cover fund redemptions when spreads increase.

Increasing financial integration of emerging markets

Bond markets

Despite the extreme volatility in debt and equity markets late in the year, 1997 also saw developing countries deepen their participation in international financial markets. There were market debuts by sovereign borrowers (Croatia, Moldova), subsovereign borrowers (Buenos Aires, Moscow), and corporate borrowers. Corporate debt issue, which had risen from $2.1 billion in 1991 to $23 billion in 1996, jumped to $36 billion in 1997.

And there was increased diversification and expanded use of more sophisticated finance instruments. International bonds issued by developing countries had greater currency diversification, including a Mexican issue denominated in euros (in advance of the introduction of the European single currency) and domestic currency issues on international markets by Argentina and a South African utility. The growth in bond issuance was aided by market innovations, including the recent development of collateralized bond and loan obligations. Under this structure, unrated developing country bonds or loans are packaged together and used as collateral for notes. The notes can be enhanced by issuing notes of lesser dollar value than the debt instruments used as collateral and by using guarantees (such as standby letters of credit). The notes also qualify for a higher credit rating than individual bonds because they are more diversified. This structure has enabled institutional investors (such as insurance companies) that are restricted to highly rated debt securities to lend to developing countries.

Derivatives

The growing use of derivative instruments also demonstrates the greater depth and sophistication of emerging markets (box 1.2). Derivatives can improve the efficiency of markets. Derivatives such as futures and options allow commercial users of markets to hedge their risk of financial loss due to price changes, thereby lowering the costs facing a business (for example, by improving the ability to attract debt and equity funds). Futures markets, when they work well, are a price discovery mechanism for the collection and dissemination of information on expected prices. Derivatives can also improve the efficiency of markets by encouraging increased participation by speculators, who can add liquidity and help prices to converge with underlying fundamentals.

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Derivatives also have their drawbacks, and they may not produce all of these economic benefits. They can be very complex, and there are serious questions about the demands they place on the limited capacity of markets and regulators, particularly in developing countries. They facilitate more leveraged positions and other forms of increased risk, sometimes resulting in spectacular losses by individual institutions. The complexity of derivative transactions can reduce the transparency of the accounts of corporate and financial institutions, thus increasing risks for investors and complicating banking supervision. And considerable controversy has surrounded the possible contribution of derivatives to speculative pressures against exchange rates and to the sharp declines in equity prices during the East Asian currency crisis.

Foreign exchange and interest rate derivatives are probably more important to emerging markets than are equity derivatives, since a wide variety of investors, traders, and other market participants are exposed daily to currency and interest rate fluctuations. According to Brazil’s Bolsa de Mercadorias e Futuros, the third-largest derivatives market in the world in number of contracts traded, interest rate products accounted for more than 60 percent of its turnover in the past three years. Activity in listed (or standardized) foreign exchange and interest rate derivatives appears to be limited in other emerging markets, although a number of Latin American markets are planning listed products or have introduced them. The bulk of derivatives trades take place in over the counter (or structured) products.

Anecdotal evidence suggests that onshore and offshore over the counter activity in structured derivatives (such as options, equity swaps, and equity-linked notes) is sizable in some of the larger emerging markets. The use of standardized equity derivatives has also increased in recent years. An investor or speculator wishing to take a position in East Asian stock markets could purchase derivatives contracts on five indexes (covering Hong Kong, China; the Republic of Korea; Kuala Lumpur; Singapore; and Taiwan, China, ) and match the Morgan Stanley Combined Far East Index (excluding Japan) with only a 4 percent error. Among European countries, the Czech Republic, Hungary, Poland, the Slovak Republic, and Russia introduced standardized derivative products in 1997. A combined index is listed on the Austrian Stock Exchange to track the Czech, Hungarian, Polish, and Russian markets.

Hedge funds

Another important institutional development has been the growth of hedge funds. Under U.S. law hedge funds are private investment partnerships with wide flexibility to invest in securities or financial futures and few regulatory requirements. Hedge funds domiciled in tax havens (such as Bermuda) have no legal limits on the number of non-U.S. investors, and some meet U.S. Securities and Exchange Commission requirements for accepting U.S. investors.4 Hedge funds invest in a wide variety of investment vehicles, including equities, bonds, currencies, and derivative products. Typically, they supplement their equity with a high degree of leverage.

The number of dedicated emerging market hedge funds increased from 5 (with assets of $682 million) in 1992 to 57 (with assets of $7.1 billion) in 1997 (table 1.6). 5/ Dedicated emerging market hedge funds have only a small share of worldwide hedge fund assets, which are estimated at $300 billion (Rodgers 1996). Emerging market hedge funds earned a compound annual return of 19 percent from 1992 through mid-1997; emerging market equity mutual funds earned 12 percent over that period. The volatility of returns was greater for the more highly leveraged activities of the hedge funds, however.

Table 1.6 The rise of emerging market hedge funds, 1992–97

a. As of July.
Source: Managed Account Reports, Inc.

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By and large, hedge funds dedicated to emerging markets are specialized boutiques. The average emerging market hedge fund has about $130 million in assets, and only six of these funds manage more than $250 million in assets. Many hedge funds have chosen specialized market sectors, such as distressed debt, Latin American bonds, or Russian stocks. Most of the funds specialize in stocks and bonds plus one or more other instruments. Twenty-five of the fifty-seven emerging market hedge funds, with $2.3 billion of the total $7.1 billion in assets, are involved in the transition economies of Europe and Central Asia, possibly reflecting the large opportunities for profit that have opened up during their transformation to market economies.

Expansion of equity markets

Developing countries’ equity markets became increasingly integrated with global markets in 1997. Emerging markets’ international equity issues rose an estimated 44 percent in 1997 to $18 billion, or from 15 percent of global issues in 1996 to about 25 percent. The surge in portfolio equity flows to developing countries in the 1990s has contributed to a substantial rise in equity market capitalization, which rose from $200 billion in 1986 to $2.1 trillion in 1997 for the 18 developing countries in the IFC Emerging Markets Global Composite Index (figure 1.5). The events of late October, when stock market declines in developing countries set off a period of volatility in industrial country markets, demonstrated the growing importance of emerging equity markets in the global economy, as well as the risks inherent in increasingly integrated international markets.

Have the returns on investments in emerging markets relative to those in industrial countries justified the huge increase in foreign investment? Over the past five years U.S. mutual funds investing in developing country stock markets have earned average annual returns of 8 percent while funds investing in the United States and Europe have earned 19 percent.6 Risks were also relatively high for mutual funds investing in emerging markets. The standard deviation of the return on funds over the past five years was 22 percent for emerging markets and 13 percent for U.S. and European funds (table 1.7). The risk-adjusted return as measured by the Sharpe ratio (which shows excess return over the risk-free rate per unit of risk7) was 0.2 for funds investing in emerging markets, much lower than the 1.1 ratio for funds investing in the United States. In short, for this sample of emerging market mutual funds over the limited time period under consideration, returns were lower and variability was higher than for U.S. and European markets. Note that the results would not change materially if the time period were extended past October 1997 to the end of the year or cut off at June (before the onset of the East Asian currency crisis).

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Table 1.7 Performance of stock market indexes and mutual funds, 1992-97

a. November 1996 to October 1997.
b. Load-adjusted returns are adjusted to count for front or back end sales charges. Index returns are not load adjusted.
c. November 1992 to October 1997.
Source: World Bank and Morningstar.

Despite the lower returns and higher risk of emerging markets over the past five years and the dramatic fall in equity prices in some East Asian markets during the second half of 1997, there are good reasons to anticipate that foreign investors will continue to be attracted to emerging markets. To begin with, the comparison of U.S. and emerging markets during the short sample time period (made necessary by the data limitations in emerging markets) may not reflect long-term trends. Returns on the S&P 500 in the United States during this period (19.9 percent) exceeded the historical average (11.1 percent) by a wide margin. And despite relatively poor returns for emerging markets over the past five years, there is good reason to anticipate that returns in those markets may exceed returns in industrial country markets over the medium term: output in developing countries is expected to rise significantly faster than in industrial countries, and differences in patterns of population growth are likely to widen the differential in expected rates of return on capital between industrial and developing countries (World Bank 1997b). Also, one way to reduce risk is to increase the diversification of a portfolio, by holding assets whose returns are not highly correlated with those on other assets, such as emerging market investments and industrial country investments. Thus investments in emerging markets can provide opportunities for improving return-risk tradeoffs in the portfolios of investors from industrial countries, even if expected returns are lower and risks are higher in emerging markets.

Another possible contributor to the lower returns in emerging markets over the past five years is the generally higher transactions costs (registries, custodial arrangements, taxes, brokerage fees, administrative costs related to failed trades, delays in dividend repayments) in emerging markets than in industrial countries. For example, total expenses (including management fees and brokerage costs) of the average U.S. stock fund are about 1.6 percent of assets, while expenses of the average emerging market fund absorb 2.9 percent of assets. Similar differences show up in the bid-ask spread, which reflects the costs of dealer operations (finance, inventories, operational costs, and some of the costs noted above). Average bid-ask spreads are 67 basis points in the United Kingdom but 130 to 170 basis points in even the more advanced emerging markets, such as Brazil, Indonesia, Mexico, the Philippines, and Thailand.

These higher transactions costs reflect the undeveloped infrastructure in emerging equity markets. Efforts to improve trading systems, provide for safe and efficient depositories, and strengthen clearance and settlement systems have great potential for reducing transactions costs and thus improving the performance of developing country stock markets. Further, developing countries need to implement regulatory reforms that improve the credibility of equity markets in order to attract both foreign and domestic investors and to realize the benefits of financial integration. Reforms would include more attention to transparency through improved disclosure, promotion of self-regulatory organizations, and credible protection of minority shareholder rights.

Continue with Development in private capital flows

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