Bond market strategy for EM governments

(Source: here)

Introduction

Emerging Markets (EM) evolve rapidly, but have yet to reach the structural maturity of developed economies. In this intermittent state, many EM economies still rely heavily on funding from International Financial Institutions (IFIs), which mainly goes to the public sector, leaving the private sector with insufficient capital, which impedes both investment and growth.

Developing a government bond market can be an important way to address this imbalance. Drawing upon my experience as a former finance ministry official in an EM country plus many years as a trader of EM bonds, I present a list of priorities for EM governments wishing to develop their bond markets as quickly as possible.

This material is technical and my target-audience is mainly EM government officials as well as anyone else with an interest in pushing EM economies forward along the arduous journey from dependence on donor finance towards genuine financial independence.

Why is finance important?

Due to widespread poverty, economic growth is rightly still considered a top policy priority in EM economies. Economic growth requires both private and public investment. Private investment involves the deployment of capital today in exchange for an expected tangible net positive stream of income in the future.

Public investment is often motivated by broader economic objectives, such as lowering the cost of doing business, addressing market failures, or achieving greater overall economic efficiency. Direct financial gain is usually not the main aim of public investment; it is usually assumed that the resulting improvements in society generate sufficient additional tax revenue to enable the government to repay its debt.

Ultimately, the rationale for developing financial markets boils down to one thing, namely consumption-smoothing. It makes more economic sense to borrow and invest today than to save for a very long time in order to make a bulky outlay in full in one go. The ability to borrow in order to invest, so as to also maintain a steady level of consumption is particularly beneficial in lower-income EM economies, where capital is more scarce and foregoing consumption is more taxing.

Structure of bond markets

Bond markets consist of securities and the institutions that issue, make markets in, and invest in the securities. Governments and corporations are the main issuers of bonds, which end up in the hands of institutional investors, who have large amounts capital at their disposal and must make a return. Investment banks sit in between the issuers and the investors and make markets in the bonds, enabling investors to trade in and out of their positions depending on how they feel about the outlook. The ups and downs we observe in markets every day are the result of thousands of traders changing views about the future and trading positions accordingly every second of every day.

Figure 1: The structure of financial markets

Source: own picture

Figure 1 illustrates the structure of a typical mature bond market in a bit more detail. On the bottom left, you have one side of the market, the borrowers. They are governments and corporations, although households can also issue tradable securities, such as mortgages. Governments and corporations source funding in capital markets in order to invest in stuff like roads and new machinery.

On the bottom right, you have the other side of the market, the lenders. They are the ones with all the money. They tend to be savings institutions, such as pension funds, insurance companies, sovereign wealth funds, and central banks, who need bonds in order to make a return. Collectively, they are known as institutional investors.

A market begins with a borrower approaching an investment bank to help them, for a fee, issue a bond, which is basically a publicly traded loan contracts with defined repayment terms and interest rates. Investment banks straddle both sides of the market with excellent ties to both borrowers and institutional investors. These ties enable them to find buyers for the bond. Once the bond has been issued, investment banks also play an important role in facilitating trading in the securities, which is why investment banks are also referred to as market-makers.

Due to the ever-increasing complexity of modern financial markets, institutional investors find it impossible to manage all their investments on their own. Institutional investors therefore outsource the management of some of their capital to asset managers, who sit in between the investment banks and the institutional investors on the right side of the chart.

Asset managers tend to specialise in certain types of investments. They are divided into ‘real money’ and 'hedge funds' depending on their style of investment. Collectively, they are known as the ‘buy side’, while the investment banks are called the ‘sell side’. The bulk of trading in financial markets takes place between these two parties.

Retail investors play a big part in equity markets, but tend to be less important in bond markets.

What are bonds?

If borrowers and investors make up the organs of the bond market organism, then the bonds themselves are the blood stream. Put simply, bonds are simply debts, which are actively traded. The rationale for trading bonds is that the credit-worthiness of issuers changes all the time, so the odds that you get your money back also fluctuates. The constant trading of bonds in secondary markets provide important real-time information to borrowers and issuers alike regarding the perceived riskiness of the issuer.

Bonds differ from loans in that bonds are issued by governments and corporations with the specific aim that they be traded actively in capital markets. To this end, bonds come with so-called bond prospectuses, which specify what happens in the event of non-payment and other contingencies. Holders of bonds are usually considered senior to equity owners in the event of bankruptcy, meaning they get paid first, assuming there is any money left at all.

Unlike equity owners, bond holders do not have an ownership stake in the issuer. Instead, bond investors are protected by the issuer's legally binding commitment to repay the borrowed amount (‘principal’) plus a specified amount of interest at regular intervals over the life-time of the bond.

Most bonds are issued on whatever terms can be obtained in the free market, but some bonds have concessionary elements if, say, an aid agency is involved. Bonds can also be structured to include special features, such as sinking funds, early repayment options, or derivative structures in which the value of the bond changes in accordance with some exogenous variable, such as GDP or the price of a commodity.

While EM governments rely heavily on grants and concessional loans from bilateral and multilateral donors in the early stages of their development, they gradually turn to market-based finance as their institutions evolve. Bilateral and multilateral debt tends to be very cheap, but often come with conditions attached. 'Conditionality' is regarded as undue interference in domestic affairs, so most EM governments turn to bond markets as soon as they can, despite the higher cost of borrowing.

EM government bonds are denominated either in foreign or local currency. Local currency-denominated bonds tend to be governed by local law, while English or New York law is used for foreign currency-denominated securities, although these are not hard-and-fast rules. Sovereign external debt refers to bonds issued by governments in foreign currency under New York or English law, although local law can also be used on occasion.

Corporate bonds tend to be less plain vanilla than government bonds, because they are often tailored to the specific business needs of the company in question. They are denominated in a range of currencies and can embed a variety of interest rate, repayment, and derivative structures.

What are yield curves?

When a government has many bonds outstanding with different maturities you get a government yield curve. Government yield curves sit at the very heart of the financial system.

Yield is a technical term used to denote market-determined interest rates (as opposed to the fixed interest rate of the bond itself). Yield curves are usually upwards sloping, because the longer time you have money outstanding the greater the risk that something happens so you don't get your money back.

Yields move around depending on traders' perception of the riskiness of the issuer. Whenever a bond is bought or sold, the yield changes and the yield curve moves. The yield curve shows how investors currently feel about the future. Its also tells governments what rates they can borrow at any given point in time. The yield curve in Figure 2 indicates that the government can borrow 1-month money at (an annualised) interest rate of 1%, while it must pay an annual interest rate of 7.3% in order to access 30-year money.

Figure 2: Government yield curve

Source: own picture

Yield curves are powerful signalling devices. If a government is becoming less likely to default then its cost of borrowing should decline, since safer issuers have to pay less to induce investors to lend them money. Yields and prices of bonds are inversely related, so declining yields push up the price of the bond and give the investor a capital gain, provided the investor has bought the bond ahead of the hoped-for improvement in credit-worthiness.

Analogously, if default risk is seen to rise then the bond yield will rise as markets will demand more compensation (a higher interest rate) for lending to the less safe government. The higher yield pushes down the bond price, which inflicts a capital loss on the bond holder.

Unsurprisingly, investors in government bonds spend their whole lives forming expectations about how the future riskiness of issuers will evolve.

Corporate bond markets work the same way as government bond markets with one important difference; corporations can be taken to court more easily than governments. If a bond defaults, it continues to trade, but now it trades based on expected recovery value rather than the risk of default. Recovery values for corporate and government bonds can differ significantly.

How yield curves are used to price risk

The information provided by movements of yield curves is so useful that most EM governments want to build yield curves as soon as they can. Suppose a government has issued bonds and established a sovereign yield curve and suppose the finance minister wants feedback on a new reform idea. All he has to do is call a press conference and present his idea.

Investors will listen to every word the minister says and, in real time, react to his proposal either by buying or selling bonds. Selling will tell the minister that markets do not like his idea. Yields will push higher, which will trigger capital losses for investors, who will sell until they think yields reflect the new higher level of riskiness. Buying, on the other hand, will be seen a positive for the reform. Yields will fall, which leads to capital gains until yields price in the new better outlook. The market may also not move at all, which will tell the minister that the market either fully expected his announcement, or that the reform he is proposing will not change the country's credit-worthiness at all.

The power of bond market signals should never be under-estimated, because - remember - the government yield curve is the interest rate structure for the entire economy, not just the government. All other borrowing rates get pushed higher if the government bond yield rises, because the government is ultimately to safest credit due to its unique ability to tax and print money to service debt. Thus, when governments mismanage their finances and their yields blow up then all other yields in the economy tend to rise as well, quickly turning a government crisis into a nation-wide economic debacle.

We only need to go back a few years for a great example of this dynamic. When UK Prime Minister Liz Truss put forward a completely unsustainable budget proposal, investors instantly sold UK Gilts, pushing yields so high that they threatened to derail the housing market. Truss was forced to step down within days. Thankfully, Liz Truss-type blow-ups are relatively rare as most governments fully appreciate the power of bond markets.

Government yield curves also add value in more normal times. For example, they enable corporations to issue bonds, since most corporate bonds are priced as a spread over the sovereign yield curve. This is illustrated in Figure 3. The left axis shows yields (market-determined interest rates), while the right axis shows the additional interest (spreads, in basis points) a corporate must pay to borrow money at a given duration. In this example, the government can borrow 30-year money at 7.3%, but the corporate must pay 200bps basis points more (9.3%). The 200bps interest corporate interest rate premium (yellow bars) reflects the market's perception of the additional repayment risk of lending to the corporate relative to the government at that duration and at that precise moment in time. This information is useful to the corporate, which now knows the financial cost of its investment idea.

Figure 3: Corporate bond spreads

Source: own picture

Investors use yield curves to compare countries in terms of credit-worthiness. Government yield curves are comparable across countries as long as bonds have the same structure, the same legal framework, and the same currency. Suppose you manage a whole portfolio of EM government bonds. You would expect higher yields for poorer countries with narrower tax bases and less developed financial markets since they face greater repayment risk than richer countries with broader tax bases and deeper financial markets. Countries with 'worse' governments typically also have higher yields (think Argentina, Venezuela). Yet, both the fundamental risk metrics and how risk is priced in the market change all the time, so there is usually plenty of opportunity for EM traders to find value.

What is the aim of a bond market strategy?

EM countries face an entirely new set of risks when they transition from donor funding to market-based finance. While this should not deter EM countries from entering capital markets, it is nevertheless important that policy-makers understand what they are getting into. Financial markets can be bit of minefield. A bond market strategy is designed to make the journey from donor dependence to bond financing as fast, efficient, and safe as possible.

Ideally, the final destination is one in which most of the debt financing needs of the government and corporations can be met by issuing bonds in local currency within large and liquid domestic capital markets. Some EM countries are already close to this ideal. Brazil, Mexico, Poland, Indonesia, Thailand, South Africa, South Korea, and others have quite advanced financial systems, but many other EM countries still have a long way to go.

The ideal is to end up with something akin to the US Treasury market, which is the most sophisticated and efficient bond market in the world. The US Treasury market has reached a state of maturity, where the US government can:

·      Meet all its financing needs at home at the lowest possible cost.

·      Eschew overseas issuance, expensive illiquid loans, or conditional finance.

·      Avoid FX mismatches, since tax revenues and interest payments are all denominated in US Dollars.

·      Borrow at lower cost in recessions. US Treasury bond yields decline in recessions, which it reduces the government's borrowing costs precisely when its tax revenue drop, thereby protecting the public finances.

While the US Treasury market is not risk-free - see here - confidence in the US Treasury market remains high enough that foreign investors, including central banks, still happily hold US Treasuries, thereby enabling the US government to tap into a truly global pool of capital.

EM governments will also want their own bond markets to emulate, as far as possible, the liquidity of the US Treasury market. Liquidity refers to the ease with which traders can buy or sell securities. The US Treasury market is highly liquid due to the huge number of transactions take place every second of the day. With price-discovery is close to perfect, the Treasury market sends out highly accurate signals about the government's cost of borrowing. Investors need not worry about whether they can buy or sell Treasuries and corporates can price their own bonds off the Treasury curve safe in the knowledge that they have a reliable basis for calculating the spread to their own bonds.

Priorities for developing government bond markets in EM

While no EM government bond market is anywhere near the US Treasury market in terms of sophistication, the journey is ultimately more important than the destination. The idea behind an EM bond strategy is not to copy the US Treasury market, but to move in that general direction. In no particular order, here are my top policy priorities for ensuring this happens.

1: Get the banking system ready to support the bond market

Bond markets cannot function without banks. A subset of banks, usually the strongest, should be designated as primary dealers. Primary dealers are pre-approved to participate in government bond auctions. They are required to buy all the bonds on offer, so the government never has to worry whether it can raise the money it needs, although, importantly, the interest rate at which the bonds are issued is determined purely by supply and demand.

After the primary dealers have bought bonds in the government bond auction, they sell them to asset managers, who manage portfolios on behalf of institutional investors, such as pension funds, insurance companies, etc. Banks play a key role as market-makers in secondary markets, facilitating ongoing trading of bonds between buyers and sellers.

Asset managers and institutional investors are free to deal with each other away from the banks, but doing so can be risky, because of poor price discovery. The big advantage of channelling trades through the banks is that volumes are high so price discovery is very efficient, assuming adequate competition between the banks.

Lack of competition between banks is actually a bit of a problem in many EM financial markets, so a big part of getting the banking system ready for bond markets is to engender greater competition. Competition drives the spread between bid and offer down, so that yields in the market reflect the riskiness of issuers rather than the market power of the banks.

Banks also play an important role in providing research on issuers, government policies, and the broader political and macroeconomic backdrop. In bringing their insights to investors, bank analysts help the market to price risk better.

2: Get regulation ready for bond markets

Banks need to be properly regulated. As we saw in Figure 1, banks see both sides of the market, which puts them in position to 'insider trade' unless they are prevented from doing so by Chinese walls.

It is critical that EM governments establish strong and independent banking regulators. Regulator pay should be commensurate with banking sector pay in order to attract effective regulators, who are less likely to be 'captured' by the banks.

Even so, it is unwise for anyone - governments and investors alike - to rely exclusively on bank research, since banks often struggle to handle conflicts of interest, especially in poorer countries. It is entirely legitimate to be suspicious of bank research on the government policy if the bank also happens to be making big fat fees from helping the government come to market, for example.

Failure to regulate banks can precipitate major exploitation of savers and investors. It can also have catastrophic macroeconomic consequences due to the systemic role banks play in the economy. Banks love that they are systemically important and will, if allowed, ruthlessly exploit their position to take excessive risks in the knowledge they will be bailed out by the government if a crisis happens. This should never be allowed to happen.

3: Build an institutional investor base

Institutional investors end up as the final holders of the bonds issued by governments and corporations. Unlike retail investors, institutional investors have long investment horizons, which enable them to make long-term bets. Their presence therefore makes markets operate more smoothly, imparts stability. This is why encouraging the emergence of an institutional investor base ought to be a top priority for any EM government wishing to create a well-functioning bond market.

In EM, the main institutional investors are pension funds, although the fastest growing segment of the institutional investor base is insurance, especially in Asia. A few EM countries have sovereign wealth funds, especially in the Middle East, but they tend to invest in foreign assets as do central banks.

The starting point for building an institutional investor base is pension reform. You want to avoid a single behemoth government pension fund or social security fund. To get genuinely competitive and liquid markets, you want many market participants, which requires multiple private pension funds alongside the public system.

There are plenty of examples of successful pension reform in EM, which have contributed significantly to the development of local bond markets. Mexico was a notable first mover. Chile and Panama have also made great strides.

In Africa, Nigeria undertook a successful pension reform in the late 1990s, which introduced privately run, defined-contribution pension plans under the supervision of Pencom, a well-run government regulatory agency. Over time, the Nigerian pension system has become steadily more sophisticated. At first, pension funds only bought government bonds, but as their capacity improved they began to invest in other assets, such as equity and corporate bonds. Today, the Nigerian pension system is an important source of long-term capital not just for the government, but also for broad swathes of the private sector.

The rationale for undertaking pension reform in EM countries is particularly strong due to benign demographics. The large number of very young people in lower-income countries means that contributions rise faster than commitments for years, even decades, thereby providing critically important finance for the economy at a stage of development, where access to other sources of finance can be challenging.  

Asset managers still only play a small role in most EM countries. It is highly desirable to stimulate the growth of asset management firms early, because the larger the number of market participants and the greater the sophistication the more efficient the market. Participation of foreign asset managers in local markets should be encouraged, but top priority should be given to developing a local asset management industry.

4: Get foreign participation right

In general, it is desirable that foreign investors participate in local bond markets. Foreign inflows strengthen currencies, drive down the term structure of interest rates, improve business confidence, and improve growth prospects through knowledge transfer. Foreign involvement in local markets also deepens liquidity and improves market discipline, since foreign investors tend to have extensive experience of and insights from other local markets.

Still, EM governments should not rush head-long into opening local bond markets to foreign investors. One of the big potential pitfalls of foreign involvement is currency volatility. Foreign investors’ portfolios are usually denominated in US dollars, so when they take positions in the local market they invariably incur a currency mismatch. It is still quite poorly understood that issuing bonds in local currency does not insulate a country from currency volatility. It all depends on the investor base. If investors are predominantly foreign with portfolios denominated in foreign currency, or even if the investor base is entirely local, but able to shift funds overseas without restriction, then there is no protection against FX volatility by issuing bonds in local currency.

To illustrate this important point, suppose a London-based Emerging Markets specialist enters the Malawian Kwacha-denominated government bond market, which is both small and illiquid. The investor first sells US dollars to buy Malawian Kwacha. This trade alone may well drive the Kwacha higher depending on the size of the flow. The investor then uses the Kwachas to buy local bonds, which may well drive local bond yields sharply lower. During the time the foreign investor holds the bonds, he or she will have Kwacha exposure and naturally be extremely sensitive to movements in the Kwacha-Dollar exchange rate. Kwacha appreciation increases the Dollar value of the position, but a weaker Kwacha inflicts losses in Dollar terms. If the Kwacha drops by more than the interest rate on the bond then the entire position is under water. At that point, or probably earlier, the foreign investor will turn tail. The resulting outflow can sharply weaken the Kwacha and cause major upheaval in the local yield curve.

Capital flight of this kind can be extremely dangerous. Capital flight episodes can become self-fulfilling and extremely destabilising for the real economy, even de-anchoring inflation expectations, since inflation expectations in many EMs depend heavily on the direction of currency.

The best way to minimise flight risk, while at the same time retaining the benefits of foreign involvement, is to prevent foreign ownership of local bonds from becoming excessive relative to the size of the local bond market. A reasonable starting point for the foreign share of bonds is probably somewhere around 10%-20%, rising slowly as the depth and breadth of the market improves.

EM governments can also vet foreign investors according to investment style. China successfully pursued a very selective approach to opening its government bond market to foreign investors to minimise volatility. China first opened its market to central banks and sovereign wealth funds, then to qualified institutional investors, and only much later began to allow volatile retail investors and hedge funds to participate. Long-only investors are preferable to hedge funds, while institutional investors are preferable to retail investors.

5: Understand the proper role of external debt

Sovereign bonds denominated in US dollars (commonly referred to as ‘external debt’) often get a bad press. Defaults on foreign currency-denominated debt draw massive media attention, because the bonds are primarily held by foreign investors. Moreover, Dollar bonds tend to be issued under English or New York law, so all the post-default legal shenanigans take place in Western courts, which are easy for journalists to monitor.

In my opinion, the animosity against Dollar sovereign bonds is largely misplaced. In fact, this asset class has many significant advantages, which include:

(a) Early access to global capital: By issuing external debt, EM governments can tap into global capital well before their local bond markets are ready to absorb equivalent volumes of foreign capital. As a general rule, inaugural bonds should be benchmark-sized (USD 1bn) and index-eligible, with, say, 5-year or 10-year maturity. As local markets evolve, the reliance on external debt should be scaled back.

(b) Lower interest payments: The rate of interest on Dollar-denominated debt is often lower than the interest rate on local currency-denominated bonds due to the absence of FX risk (from a foreign investor perspective). This means that the recurrent fiscal burden for the government is lower too, albeit in foreign currency.

(c) Manageable FX risk: The FX risk associated with external debt is completely predictable from the day the bond is issued. For example, if an African government issues a USD 1 billon 10-year fixed coupon sovereign bond with an interest rate of 12.9% then the government knows with complete certainty that the annual interest payments will be USD 129m and that the final principal repayment of USD 1 billon will fall due exactly ten years hence. In other words, governments can easily plan for these cash flows.

(d) Rapid feedback for policy-makers: Investors in external debt have vast experience of investing across countries, so their trading decisions offer valuable insights for EM policy-makers. External debt markets react almost instantly to changes in government policy or exogenous shocks, so EM governments are able to adjust policy almost immediately without having to wait for months to see what happens in the real economy.

(e) Making spread-tightening a policy objective: The spread of a country’s external debt over the US Treasury curve is comparable across countries. If Malawi’s sovereign bond trades at a narrower spread than, say, Zambia’s sovereign bond then Malawi can confidently claim to be more creditworthy than Zambia. Tighter spreads relative to comparable countries can be made a useful policy objective with clear political and economic benefits.  

(f) Dollar financing for corporates: The existence of sovereign Dollar yield curve enables corporates to price Dollar bonds of their own off the sovereign curve, thereby gaining access to Dollar funding markets. This can be especially useful for companies with large commitments in Dollars, such as mining companies.

Turning to risks, the main risk of external debt is roll-over risk, i.e. having to repay a very large principal in foreign currency at final maturity. To reduce this risk, governments can do a number of things. In general, they should always monitor market conditions for opportunities to refinance upcoming maturities. It is very unwise to wait until the last minute to refinance, since markets may turn sour at that precise moment in which case the government is either forced to refinance at very unattractive rates, or default.

Governments can also manage roll-over risk by setting aside funds for principal repayments in escrow accounts during the lifetime of the bond, so that the required funds will be available at final maturity. Gabon did this. One benefit of sinking funds is that investors like them, so governments with sinking funds can usually issue bonds at lower interest rates.

Optionality to repay a bond early can also be introduced into the bond structure, but departures from plain vanilla structures often reduce liquidity, since many bond indices do not cater for bonds with derivative structures.

As a general rule, external debt mainly has a role to play before local bond markets are large enough to absorb meaningful volumes of foreign capital. Over the years, many EM countries started by issuing sovereign Dollar bonds before gradually becoming fully reliant on local bond markets. Thailand is a case in point.

6: Don't lose sight of corporate bond markets

Ambitious EM governments understand the importance of corporate bond markets. EM corporate bond markets are less developed than EM government bond markets, but they are arguably more important, since the private sector must be the main driver of economic growth. To fulfil this role, the private sector needs access to funding.

Today, in many EM countries, corporates rely entirely on bank loans, if they can get any at all. Many EM banks often do little else than take deposits and investing them in local government bonds, failing the private sector completely. By encouraging the development a corporate bond market, EM governments give businesses an alternative to bank loans, which can can result in significantly better borrowing terms for business.

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A few other pieces of useful advice

In addition to the priorities listed above, I know want to mention a few other useful things EM governments can do to ensure a good bond market experience.

1.     Hire a resident technical advisor: In the past, the US Treasury seconded experienced treasury officials to debt management units within EM finance ministries. Ghana benefited significantly from the insights of an advisor in the lead-up to the country’s inaugural sovereign bond issue in 2006. There are also many experts with vast experience of EM bond markets in London, New York, and other financial centres. A resident technical advisors is useful for many reasons; they can assist in building capacity to better engage with financial markets, identify critical reforms, guide regulators, get statistics departments up to scratch, educate finance ministry staff about markets, obtain financial information and trading systems (such as Bloomberg), set up bond auction and settlement systems, develop ties with local market-making banks, manage relations with international investment banks, obtain sovereign credit ratings, and other areas of critical importance to financial market development.

2.     Get government statistics in order: Investors evaluate credit-worthiness by establishing the government's ability (and willingness) to pay. Investors therefore pay close attention to government statistics, which should always be accurate, consistent, and timely. They should be produced independently of the government and be publicly available.

3.     Get a sovereign credit rating: The big three credit rating agencies are Fitch, Moody’s, and Standard & Poor’s. Other ratings agencies specialise in local bond markets. Bonds with credit ratings trade tighter than bonds without credit ratings, so getting a rating, while expensive, ultimately pays off.

4.     Hire an external financial advisor: Before coming to market, the government should hire an external financial advisor, who will bring the bond to market. Such advisors usually hail from investment banks and have vast experience in all aspects of financial markets, including how to bring bonds to market, preparing presentations, legal matters, roadshows, etc. They can advise governments how best to manage repayments, etc. Governments should make sure that the investment bank they hire has good ties with institutional investors most likely to buy EM bonds. The best performing bond issues are those, which are placed with long-term institutional investors rather than so-called flippers or retail. It is essential that inaugural bond issues do well, because first issues tend to set the tone for subsequent bond issues.

5.     Go on roadshows: It is critical that sovereign issuers reach out to investors well ahead of bringing a bond to market. Business is best when it is based on trust. EM governments should therefore ask their external advisors to arrange initial non-deal roadshows in key markets like Europe, the US, and Asia. The purpose of a roadshow is to disseminate information about the country and the government’s interest in financial markets. Roadshows enable government officials to meet end-investors, learn about markets, and build information networks. Delegations are often led by the finance minister, but it is often better for investors to meet the senior officials, who are directly involved in the day-to-day management of the public finances. Foreign investors are usually very well informed and are likely to ask technical questions, which ministers may not always be best-placed to answer.

6.     Listen to end-investors, not just the banks: Government issuers should never rely exclusively on investment banks for information. Investment banks will generally try to make as much money as possible for a minimum effort, especially with inaugural issuers, who don't come to market very often. EM governments should supplement whatever information they get from investment banks with information from investors. Investors appreciate personal contacts very much. It is particularly important to speak directly to EM specialist investors, such as Ashmore Group plc, the EM division at Blackrock, Stone Harbor Investment Partners, Investec, BlueBay Asset Management, and others, who will offer frank and constructive advice, because, like the government itself, they ultimately want the bond to do well.

7.     Sell yourself: Ahead of a bond launch, the government should prepare a good and thorough presentation that sets out a strong but honest case for investing in the country. The presentation should include a complete set of statistics on macroeconomic fundamentals, including detailed breakdowns of the balance of payments, public finances (above and below the line), and debt sustainability metrics. There should be an overview of the structure of economy, clear illustrations of sources of government revenue and foreign exchange. Ideally, a recent IMF Article IV report should be available. The presentation should also state clearly how the government intends to make use of the funds raised in the bond issue and how it intends to repay the money. The presentation should also include an explanation of the country's political situation, highlighting major upcoming political events, such as elections. Officials should be prepared to answer challenging questions.

8.     Make bonds euroclearable: Newly issued bonds should be euroclearable. Euroclear is an organisation, which matches buyers and sellers in global bond markets, i.e. it settles bond transactions. Being part of the euroclear system means faster and more efficient settlement, which is highly valued by investors. Euroclear settlement can also be arranged for local currency bonds and is recommended.

9.     Aim to make bonds index-eligible: Governments should strive to include all its bonds – local as well as external – in the main bond indices. Index-eligibility guarantees participation from a larger and higher-quality base of investors. Many institutional investors only buy bonds if they are eventually included in benchmark indices. The downside is that index-eligibility usually requires bonds to be plain vanilla with a certain minimum size. Many banks provide benchmark indices, but the most used benchmark indices in EM are the suite of indices produced by JP Morgan’s index group.

10.  Aim to maximise liquidity: Investors love liquid bonds, not because they want to sell them outright, but because they are easier to trade. Hihgly liquid bonds quickly become investor favourites, some even become legendary (personally, I have fond memories of trading the Brazil A bond and the Vennie 27 bond). The way to maximise liquidity is to issue large, euro-clearable, index-eligible bonds in the standard 1-year, 3-year, 5-year, and 10-year sectors. Existing issues can be re-tapped to increase size further. EM issuers should generallly avoid issuing many small non-fungible issues. Chile used to have problems with liquidity in its local bond market due to too many off-the-run issues. Lesson: study the experiences of other countries to learn about the best ways to maximise liquidity. 

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