Liquid dreams: Prudent macroeconomic policy set to improve access to financial tools

Fixed income in Colombia is a tale of two markets: a well-established and highly liquid sovereign bond market, accounting for about 80% of bonds traded, and a still-developing, less-liquid corporate bond market. Together, they amounted to $840bn of the total $1.12trn of financial assets traded in Colombia in 2012, indicating their relative strength in terms of liquidity compared to other asset classes. Total trading in bonds experienced compound annual growth of 22% from $140bn in 2001, peaking at $142bn in 2010. Average daily traded volume was $3.4bn in 2012. Strong domestic macroeconomic fundamentals coupled with loose monetary policy globally have raised demand for Colombian fixedincome assets during late 2012 and early 2013. This has seen yields fall dramatically, with the yield on the 2024 benchmark sovereign bond dropping from above 6% to below 5% over a two-month period.

INFLATION: Given the sensitivity of bond prices to the interlinked trends in inflation and central bank interest rates, it perhaps comes as no surprise that the longterm downward trend in the latter has supported prices in the former. Prior to 1999, double-digit inflation was the norm in Colombia. Although inflation peaked at 7.67% in 2008, before falling to 2% the following year with the onset of the global financial crisis, the longterm trend is clearly downwards. Year-on-year inflation had fallen to 1.83% by February 2013 and was expected to remain below the middle of the central bank’s 2-4% targeted range by year-end 2013. Local market players view the shift to low inflation and lower bond yields as being structural in nature.

TAX REFORM: In late 2012, the government changed the tax regime governing the international holdings of Colombian fixed-income assets. Having previously been taxed at 33%, capital gains on these assets now attract a tax rate of only 14%, with the exception of holdings in international tax havens that will henceforward attract tax at a rate of 25%. Although equity holdings continue to attract no tax on either dividends or capital gains, for either domestic or international investors, the recent reforms have made Colombian fixed-income assets more attractive to international investors. While the full impact of these reforms had not become clear by early 2013, there is some evidence that they provided a fillip to international demand, improving liquidity and reinforcing the downward trend in bond yields.

SOVEREIGN BONDS: Government treasury (TES) bonds are the most liquid asset in Colombian financial markets, with some $80bn in issuance, the vast majority of which are now denominated in pesos.

There are two types of TES bonds: fixed rate and inflation-linked, the former being more liquid. TES bonds are issued in multiple tenors, giving rise to a comprehensive yield curve for both the fixed-rate and inflation-linked markets. The 10-year, fixed-rate TES bond maturing in 2024 is the market benchmark, and the most liquid tenor. The 2026 bond has recently been gaining in liquidity, while 2028 is the longest maturity currently available on the market. At the shorter end of the yield curve, the 2015 and 2016 tenors are the most liquid. Overall, fixed-rate TES bonds account for $2bn in average daily trading volume.

With an average daily traded volume of only $150m, inflation-linked – or UVR – TES bonds are less liquid than their fixed-rate siblings. They are denominated in units rather than in currency, with the Colombian peso (COP) or US dollar (USD) value of transactions thereby extrapolated. Of these UVR bonds, those maturing in 2015 and 2023 are the most liquid. An issue with maturity in 2028 is envisaged during 2013.

Colombia also issues sovereign bonds on global markets with denominations in both COP and USD. The most common of these are those issued in USD, with fixed rates, maturities up to 2032, and average daily trading volume of $150m. Global TES bonds are those issued internationally, denominated in COP, but repayable in either COP or in USD. Although less liquid than their locally traded cousins, they often serve as their price reference points. Historically, locally traded TES bonds carried a premium of 200-300 basis points, but this had narrowed by early 2013 to 60-80 basis points as international investors become attracted to the local market, not least given the abovementioned tax reforms. As of early 2013, local market participants remained unsure as to whether this spread would narrow further.

CORPORATE BONDS: Overall, bonds issued by Colombian corporates are less liquid than their sovereign counterparts. Corporates can also be fixed rate or inflation-linked in nature, but the latter are more liquid and denominated in pesos rather than units, in contrast to government bonds. For this reason, they are more often compared to fixed-income rather than inflation-linked sovereign bonds. Total average daily volume on the corporate bond market is $200m, 95% of which is accounted for by inflation-linked bonds. Corporates have raised $17.7bn on the primary market since 2010, $11.8bn in 2011 alone. While 2012 was not a stellar year for corporate bonds, issuance of $1.7bn in the first two months of 2013 suggests a pick-up in activity as firms take the opportunity to raise debt finance at low interest rates. There is strong appetite from local institutional investors for more dynamic primary and secondary bond markets with more issuance, more diversity and more liquidity. There is also high demand for more liquid alternatives to TES bonds.

INFRASTRUCTURE BONDS: To address Colombia’s infrastructure deficit, the government has set out a $24.4bn plan, dubbed “4G”, involving 30 separate projects. Given fiscal constraints, it is necessary to mobilise private sector resources: a new law on public-private partnerships has been introduced, while the National Infrastructure Agency is in the process of developing infrastructure bonds in consultation with local pension funds and other financial players.

Although there is investor demand for such new private sector fixed-income assets, it appears unlikely that these will come on stream prior to 2015, given that they are not used to finance the construction phase. One key challenge will be achieving an appropriate alignment of interests and allocation of risks and rewards between government, concessioners and institutional investors. Given the heterogeneous nature of infrastructure projects, it is difficult to develop sufficiently standardised financial instruments to sustain a vibrant secondary market in a country the size of Colombia. In essence, the interested parties are attempting to develop a suite of financial instruments that would see the early stages of infrastructure construction financed through large equity tranches, then re-financed through debt issues once construction risks have been overcome and operational risks minimised.

DERIVATIVES: The market for derivatives in Colombia is at a developmental stage. Given the links between the foreign exchange and fixed-income markets, it is logical that foreign exchange derivatives are the longest established and most liquid. Forwards in the USD-COP market are particularly prevalent. Futures on the foreign exchange and TES bond markets have also been introduced. Although demand for the latter has not increased to the extent that had been anticipated, there was evidence of an acceleration in 2012 and early 2013. This trend is expected to continue with the launch of COLTES in 2013, a futures contract tied to Colombian sovereign bond tenors. There are no standardised credit default swaps (CDS) in TES or corporate bonds, but these are available on an over-the-counter basis. In Colombia, CDS are typically used for information purposes rather than for hedging against credit risk.

KEY PLAYERS: Domestically, pension funds are the dominant holders of Colombian fixed-income assets, with insurance companies and long-term investment trusts also playing a central role. Juan José Lalinde, president of Fiduprevisora, a local investment trust company, told OBG, “Trusts have also been a great ally of retail investors and the trust sector has 76% of the participation of the collective portfolios.”

There is some evidence of a recomposition in the asset portfolios of domestic banks, with a small shift from lending to investment, and a consequent increase in demand for financial assets, notably bonds. Local brokers are active traders, but they have shifted towards an execution-only model rather than trading on their own resources as seen previously. The government designates market makers, while three to four primary dealerships for sovereign bonds are assigned by means of a Dutch auction. Local players expect demand for Colombian fixed-income assets to remain robust going forward as the impact of the recent tax reforms is felt and as the country’s reputation as a stable emerging market with low inflation becomes further entrenched.

Following Fitch’s March 2013 upgrade of its outlook on Colombia from stable to positive, after a similar move by Standard & Poor’s in August 2012, there is confidence that the sovereign rating will be upgraded one notch to “BBB”, further into investment-grade territory, in late 2013 or early 2014. Such an upgrade can be expected to expand the potential investor pool for Colombian bonds, providing support for prices. Infrastructure bonds are expected to be an important driver of development of the corporate bond market, but few are expected to come on stream before 2015.