The popularity of some seemingly high-risk frontier bond issues suggests investors are driven by the need to fill index allocations rather than issuer quality. It also suggests the traditional market-capitalization approach of indices needs reconsideration.
Recent low issue prices of bonds from new, frontier credits have surprised many long-standing fixed-income bankers and investors, who are pondering why demand has been so strong despite the obvious risks associated with some of these transactions. Some are now asking: if fundamentals do not reflect the risk-reward relationship, is the once-marginal bookbuilding issue of technical, index-driven demand perhaps responsible for some of the over-subscription? And, if so, could investor behaviour be about to lead to even greater technical-demand issues as investors look away from traditional market-capitalization-based indices towards other, less liquid, bond indices?
“Did you read the list of disclaimers in the Bolivia prospectus?” asks one senior Latin America DCM banker. “It reads like a list of possible horror stories, and yet they priced at 5% [actually 4.875%].” It’s not just the pricing level of new Latin American frontiers such as Bolivia and Paraguay that have had some scratching their heads, deals such as those for Nigeria and Romania all priced more strongly than expected. Being frontiers they carry idiosyncratic risk – and therefore differ widely – and in some cases arguments can be made that risks are being properly priced. But there remains an open question about whether or not inclusion in the leading bond indices is generating zombie demand – investors subscribing to new issues simply to own the index – an activity that distorts bond yields.
As the list of smaller, illiquid deals is added to an index the problem becomes theoretically worse: for example, the JPMorgan EMBI Global added Angola, Bolivia, India and Zambia in the fourth quarter alone, bringing the number of countries included up to 55 from the 42 at the end of 2011. As one of the world’s leading bond indices covering dollar-denominated issuance by emerging market sovereigns, it is used as the benchmark for many investors. The minimum threshold size for a deal to be included in the JPMorgan EMBI Global is $500 million, and with the proliferation of smaller deals of this size some investors might simply be subscribing to avoid deviating from the index.
“Technical demand from being included [in an index] is a big deal for frontier-market transactions,” says Richard Oswald, managing director, fixed-income product management, at JPMorgan Asset Management. “It’s not just in fixed income, you see it in equity indices too. Portfolio managers have to decide whether to participate by buying stock when new companies are added to their benchmark index, or whether to allow an increase in their tracking error.”
For the full story go to Euromoney
See also “Pimco aims to make the most of its advantage in GDP-weighted indices”