Institutional investors hold their nerve despite emerging markets sell-off

Despite recent headlines announcing the demise of the emerging markets success story, the effect on structured products has been marginal. Apart from shorter maturities in the face of market uncertainty, few changes have been seen in how products are structured.

"More than outflows in structured products based on emerging markets, what we have seen in recent months is increasing worries from investors about the fate of those markets," says Manuel Meza, Mexico City-based managing director, global structured solutions Latin America at BBVA Bancomer. "Investors want shorter maturities to have more security, and as a consequence they are now predominantly of only one year. Investors demand less leverage and more protection – in a word, they are turning more conservative. But we haven't seen many outflows because local investors are not able to move investments outside their residence country that easily."

Although normally referred to as emerging markets, the truth is that within that group of countries there is a varied range of economies. For instance, within the Standard & Poor's range of emerging countries indexes, some benchmarks have recorded rises of more than 50% in the year to date, such as the United Arab Emirates' or Ghana's. The members of the Bric group (Brazil, Russia, India and China) have been badly hit by falls over the past nine months, weighting down the general classification of the emerging markets indexes.

Already outside of the Bric classification, South Korea has been in the headlines ever since MSCI, which runs the most popular emerging markets index in the world, announced in June that its Korea and Taiwan indexes were entering a review period for a potential reclassification to developed markets.

Taiwan has welcomed more investor interest on its path to developed status, with Barclays, for instance, successful with products that offer yields of 8-9% on US dollar-based products. Moreover, after the government set up a new regime for this type of investment in the past two years, retail investors have entered the structured products market, with the main interest in equity-linked issuance as well as long-dated hybrid and/or foreign exchange and interest-linked notes.

We see a lot of interest in Nigerian bonds among local clients, but also from international investors

The governing committee of the UK-based index provider FTSE had already decided, in 2009, to reclassify South Korea as a developed market, because maintaining Korea's classification as an emerging market would create distortions that fail to reflect the intentions of investors, according to FTSE.

Access products based on an illiquid mainland China market have also been in demand, despite the hedging difficulties. In the onshore market, the Chinese market has seen companies looking to take advantage of the new regulations implemented by the government for derivatives, with the product preference still based around simple total return swaps or equity-linked notes that are either linked to the Shanghai index or baskets of stocks.

There has also been a common desire from investors to hedge and trade in its offshore renminbi market. Structures based on the Chinese currency are becoming more common in Western investors' portfolios as they seek to take advantage of a still appreciating currency. On September 12, MSCI announced the launch of its EM Beyond Bric Index that includes 17 countries excluding the Bric group, which weighs in at 40% of the MSCI Emerging Markets Index.

If cheaper equities are an advantage for the creation of new structured products, equities in emerging markets are where the real bargains are. In the year to date, the MSCI Emerging Markets index was down 6.14% as of September 13, with the S&P Emerging BMI 5.63% lower. Moreover, whereas not every country has had a bad performance, the main constituents of the indexes are all down this year, apart from China's benchmark: the S&P Brazil BMI has fallen 13.04%, the benchmark for India reports a fall of 12.61%, S&P Russia BMI is down 4.86% and China's benchmark has recovered in recent weeks and turned positive, with a rise of 2.92%.

"Emerging markets remain on the radar of institutional investors," says Sebastien Lieblich, Geneva-based executive director and global head of index management at MSCI. "A sovereign wealth fund from the Middle East has just increased its exposure to those markets. There have been times when investors took their money out of emerging markets to return shortly after, making a very cyclical circle. When there is a downturn in a market, there is a negative psychological impact, but markets going down also create new investment opportunities."

Similar struggles over the question of whether a country qualifies as emerging or developed also fits the Middle East, a region in which structured products have been a tough sale, partially because of the extreme wealth of some its major investors. The few investors in the Middle East that do buy structured products usually do so on Western exchanges, according to Stefan Armbruster, head of passive asset management for Europe, the Middle East and Africa at Deutsche Bank in Frankfurt.

There is also a bubble being created around the high returns offered by real estate, which are difficult to beat with structured investments, says Haris Contaroudas, London-based deputy head of central and eastern Europe, Middle East and Africa sales at Société Générale. "Obviously, real estate and structured products have nothing to do with each other, but retail investors look at it that way," says Contaroudas. "They are flipping homes and making 20% in three months, and we cannot beat that."

There is also a lack of liquidity in equity markets around the Middle East region, which makes the creation of products based on local underlyings tough, especially due to the difficulties this means for hedging. The same lack of liquidity has restricted the development of local equity-linked structures in Africa, although Standard Chartered has made some progress with access products based on the local financial markets outside South Africa.

"We see a lot of interest in, for example, Nigerian bonds among local clients, but also from international investors," says Gillian Gordon, director, product specialist at Standard Chartered in London. "It is fair to say that structured products focused on emerging markets have had difficult times in recent months, but we are still expanding."

The bank has produced the FX Global Yield Model, a Group of 10 and emerging markets forex carry strategy with risk overlay. The product can be offered in a principal protected format denominated in both global and African currencies, and the bank says so far it has just under US$1 billion in assets under management. Standard Chartered also offers products linked to onshore African bonds available via a credit-linked notes, which can transform the payout into a settlement currency of the investor's choice. This trade allows investors to access the high yields that are typical of these markets and difficult to source without onshore capability, all in a relatively short tenor format.

Eyeing up the corporate bond market

Corporate bonds in emerging markets also provide excellent access to higher yields, with structured products wrappers allowing investors to overcome local restrictions. In Mexico, there are restrictions on the trade in buying credit derivatives strictly limited to banks. These banks can arrange asset swaps, instead of credit-linked notes, by structuring a cross-reference swap that will be redeemed early if the underlying bond loses value. The need to trade with corporate bonds that way put banks off in Mexico, according to bankers.

"There is no appetite for corporate bonds in Mexico," says a Mexico City-based banker at a local bank. "The Mexican market doesn't know this. We prefer to stick to simple operations based on asset swap notes, with short or medium maturities, and with simple conversions from dollars to pesos, for instance."

The offshore market in the country, in contrast to the one in Brazil, still lacks liquidity and knowledge from local investors. The few operations recorded are trades in dollars or euros, which the retail investors in the country are willing to convert into pesos. According to bankers, investors will not want to have names they are not very familiar with in their portfolios. Pemex, the national oil company, stands out among the rest of the companies the banks trade with in offshore markets, but keeping simple structures of trades from dollars to pesos.

The situation is slightly different for the other big market in the region, Brazil. Companies such as Petrobras, the national energy corporation, have a long record of bond issuance and banks are starting to structure products with those underlyings, but the market does not resemble those in the developed economies of US and Europe.

"We haven't really changed our strategies for Latin America in recent months," says Emmanuel Valette, New York-based managing director and head of cross-asset solutions Americas at Société Générale. "There hasn't been any change in the offshore markets, whereas in the onshore market of Mexico and Brazil we keep seeing the same type of demand from investors."

In the onshore markets of Brazil and Mexico, the French bank offers a varied range of maturities. In Brazil, due to high rates, the maturity of the products tend to be short, from one to two years, whereas in Mexico, maturity can range up to seven to 10 years. In the offshore market, products linked to rates and equities, as well as hybrid products, are popular and their maturities go from 18 months to 10, 15 or even 20 years. These long-maturity products are normally callable, so the real maturity of the product is expected to be shorter. Most of its clients are retail or high-net-worth individuals, which are accessed through asset managers, private banks or distributors.

"We also have credit-linked notes because investors feel safe with well-known names in their countries, such as Petrobras in Brazil," says Valette. "We can also offer vanilla credit notes, as well as hybrid notes linked to rates and credit: investors betting on the rise of the 10-year dollar swap rate, with the investment credit-enhanced by the investor taking a risk on a corporate name they are comfortable with."

Valette is optimistic about the long-term prospects of structured products in Latin America, and says that trillions of dollars could come into the game as institutional investors are looking for investments that provide good yields. "Investors struggle to get the yield they want and they will need to go for more complex products, not just vanilla products," he says. "And they will go to the structured products market. In Brazil, for instance, pension funds are now investing 0.01% of their money in structured products. Potentially, 10% of that money could go into products, and we are talking there about trillions of dollars."