Frontier Currency Bonds: A New Impact Asset Class?
How synthetic local currency bonds can transfer FX risk efficiently
This article discusses a novel structure, which allows to transfer currency risk from African borrowers to the balance sheets of international investors. The structure involves the use of synthetic local currency bonds issued in offshore markets. The article further describes how this risk transfer increases overall efficiency and how it contributes to improve the deteriorating debt sustainability situation in low-income countries in sub-Saharan Africa. Finally, it provides evidence for the growing demand of frontier FX risk in recent years and argues for the high potential of this asset class looking forward.
The Problem: Unsustainable debt in low-income countries
An increasing number of low-income countries, three quarters of which are currently in sub-Saharan Africa (World Bank, 2020), are facing a tough predicament when it comes to their ways of financing. While the development community talks about a massive financing gap to reach the SDGs, known as the “billions to trillions” rhetoric, many LDICs are already beyond healthy debt levels. The share of countries that are now close to or already in debt distress has shot up to more than 40% and almost 50% in the case of frontier LDICs.
As a result, the debt service burdens are on average the highest in sub-Saharan African countries (IMF Policy Paper, February 2020). This is partially due to the increase of general debt levels, measured by the median of public debt to GDP, which, since 2013 has risen from 35% to 55% in frontier LDICs (IMF, October 2019). To another part, however, it is the type of debt that is deteriorating the countries’ likelihood to service their debts. Therefore, an ever-larger share of attention is given to debt characteristics such as composition, maturities, currency, types of debt provider, etc., all of which influence the so-called “debt sustainability”.
The fact that debt levels are not likely to decrease, given the need of external financing to push cost-intensive infrastructure projects such as housing, education, health, transport, etc., makes it vital to provide the right kind of debt, one that is sustainable and transparent. While there are of course various factors that make a certain level of debt more or less sustainable, this article will focus on one specifically: the debt’s currency composition. The majority of LDIC public and private debt is held in US Dollar, despite a bulk of the financed assets being denominated in the country’s local currency. The graph below shows that hard currency debt issuances in frontier markets have increased sharply during the last three years, which indicates that the reliance on US Dollar is not slowing down.
The IMF’s latest policy paper notes that “since 2010, foreign currency denominated bonds have been the fastest growing source of financing for frontier LIEs, mainly in sub-Saharan Africa” and notes that Eurobond issuances have almost tripled between since 2012 (IMF February 2020). The dependence on foreign currency borrowing is often termed as the “original sin” of economics, initially used by academics to describe the inability of a country to borrow abroad in their domestic currency (Eichengreen et al., 2002).
Currency mismatches on the balance sheet expose a company (or country), to the risk of local currency depreciation. Unfortunately, it is exactly the lower-income countries that have historically experienced sudden and severe FX depreciations. This has already contributed and exacerbated financial crises in Mexico, Russia, Argentina, and large parts of Asia (all between 1994 and 2002) as well as recent shocks in Sierra Leone or Zambia.
The point is, hard currency debt is – in most cases – not the right kind of debt for borrowers in LDICs. Alas the current debt situation of most low-income countries is far from ideal. Both public and private sector in many LDIC economies are highly exposed to currency depreciation and they have very limited options to change this situation.
Proposed solution: Make debt more sustainable and transparent by transferring FX risk from local borrowers to the market
The following paragraph will discuss how the issuance of synthetic local currency bonds in international markets allows to transfer FX risk from local balance sheets in frontier markets, to the ones of international investors in offshore markets.
This structure generates a high efficiency gain, since the local borrower is often more risk averse and has less means to cope with high exchange rate volatility, while the international investor who has appetite for that risk and return profile, is more capable of managing frontier currency risk.
The FX risk transfer goes through multiple steps:
To start let’s assume that an IFI provides a loan in local currency to an onshore borrower. At the same time, it enters into a swap agreement. The cross-currency swap allows the creditor to transfer the FX risk, which arises from providing the loan in local currency, to the balance sheet of the Hedging provider. This transfer is depictured in the green circle of the graphic.
The Hedging provider’s contribution is to warehouse the accumulated currency risk and transform it. The risk transformation via volume and maturity conversion is essential for the Fund to off-sell parts of its exposure to international investors.
This transfer is achieved through the issuance of synthetic local currency bonds. The issuer, usually an IFI, simultaneously executes a cross-currency swap, matching the payment obligations, thus transferring the FX risk from the hedging provider to the investor in the bond. This transfer is depictured in the yellow circle of the graphic. While the blue arrows are representing how the currency risk is shifted between parties, the purple arrows represent the cash flows which originate from the international investor and ultimately reaches the local borrower via the IFI who uses the bond proceeds to finance development projects locally.
Emitting local currency bonds and creating markets in frontier countries is a fundamental part of IFIs and their Hedging providers’ strategy and they are working on innovative concepts to push this development even further. An interesting point to make is that for multi- but also single-currency bonds, the Hedging provider’s and the investors’ interests are aligned. Since Hedging providers usually holds long positions on frontier currency, they are similarly invested in the single or multiple currencies in which the buyer of the bond is invested.
This bond hedging structure not only allows to allocate frontier FX risk more efficiently, but is also beneficial to the other parties involved:
For the Hedging provider, offsetting part of its exposure increases the capital efficiency, allowing the Fund (e.g. TCX) to further onboard additional exposure
For the IFI, the issuance provides a cost-effective funding opportunity (usually sub- LIBOR) and establishes a cost of fund interest rate benchmark in frontier currencies, hence setting the steps for a deepening of the local capital markets.
For the investor, the bond is a tool to invest in frontier market risk without absorbing any credit risk, given that the issuer’s note is AAA rated, and the note is issued offshore in international financial markets. It also avoids any convertibility or transfer risk which is normally involved when investing in frontier markets.
The separation of credit and market risk is a unique outcome of the structure, making this asset class attractive for investors looking for high yields and diversification.
In addition, the bonds can likely be labelled as an ESG or SRI investment, given that the issuing IFI uses the proceeds to fund high impact development projects in emerging and frontier markets.
For the development purpose, the deepening of capital markets provides more alternatives of risk mitigation products to reduce currency risk while bridging the financing gap in SDGs.
Since 2013, the demand in such offshore local currency issuances has increased drastically. In 2019, TCX, for example, hedged about 14 times as much volume compared to the average of 2013-2016. The diversity in currency denominations is equally impressive. So far, bonds in more than 20 different frontier currencies have been hedged, many of which were inaugural issuances, thus contributing to the development of capital markets. The growth is also reflected in an increasing ticket size, whose average doubled from about USD 5 million to more than USD 10 million. TCX also noticed a demand for African bond issuances in local currencies including XOF, RWF, TND and TSH, totaling the equivalent of about USD 85 million.
The potential: Increasing demand anticipated due to structurally favorable environment
The aforementioned figures give a good indicator of the general appetite that private investors have in this asset class. Allowing to invest in the high yield risk-return profile of frontier and emerging market currency risk, without having attached any convertibility, transfer, legal, or credit risk, seems to be an attractive option in a search-for-yield market environment. Given that the ongoing low-interest environment is a structural feature, the long-term demand for such assets is not likely to be adversely affected by negative short-term outlooks.
While the growth in demand has been remarkable, the total volume of about USD 500 million in 2019 is small in relation to the potential market size. The latest IMF Global Financial Stability Report (IMF, October 2019) shows that pension funds have increased their share of alternative assets from an average of about 5% to 20% (see graph); similar trends are seen with other institutional investors. The same report states that negative yielding bonds have increased to about USD 15 trillion, with investors expecting the “interest rates to remain very low for longer than anticipated at the beginning of the year” (IMF, October 2019). This environment further indicates a large potential for the high yield asset class of frontier currency risk.
The valuation of the currency risk is another important issue that needs to be addressed. The fact that most of the discussed currencies are illiquid and no (offshore) interest benchmarks are available, makes the continuous valuation of the asset very challenging. However, TCX is currently working to provide regular pricing data on Bloomberg to allow for more accurate valuation. Looking ahead, a liquid secondary market with continuous pricing availability is the objective, thus deepening frontier countries’ capital markets.
In conclusion, the local currency bond structure can be considered a mechanism that is beneficial to all parties involved:
- It provides investors access to a unique and innovative asset class;
- It allows IFIs to finance themselves in de facto US Dollar at a lower cost;
- It increases the hedging provider’s capital efficiency;
- It deepens capital markets;
Last but not least, it allocates frontier currency risk efficiently, thus transferring the FX risk burden from the shoulders of local borrowers to better diversified international investors.
Introduction to TCX
A Hedging provider that has successfully operated within this structure is TCX. The local currency fund has been specifically set up by IFIs, including the African Development Bank, to hold and manage long-term currency risk from even the most frontier currencies. By hedging FX risk from a variety of IFIs, the Fund has built up a long exposure which is derived from underlying IFI loans that support development and have a real impact on the local economy. TCX is working toward structuring a multi-currency bond with one of its shareholders, which would provide investors with diversification benefits and allows for larger ticket sizes, aimed at around USD 200-300 million.
References (in order of appearance):
World Bank, 2020, Dataset on country income classification: https://datahelpdesk.worldbank.org/knowledgebase/articles/906519-world-bank-country-and-lending-groups
IMF, 2020, Policy Paper No. 20/003: https://www.imf.org/en/Publications/Policy-Papers/Issues/2020/02/05/The-Evolution-of-Public-Debt-Vulnerabilities-In-Lower-Income-Economies-49018
IMF, 2019, Global Financial Stability Report: https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019
Eichengreen et al., 2002, “Original sin: the pain, the mystery, and the road to redemption.”
 International Financial Institutions (IFIs) include multilateral and regional development banks, and national development banks with international objectives, which address the Sustainable Development Goals (SDGs)
 In a synthetic local currency loan, the cashflows are undertaken in USD, but the flows are indexed to the local currency. Thus, the currency risk is held by the creditor, in this case the IFI.
 Alternatively, the FX risk can also be sold directly by TCX via non-deliverable forwards and swaps.
About the author
Amadeus Bringmann is responsible for the Impact Measurement and Reporting at TCX. Before joining TCX, he completed his MSc in Development Management at the London School of Economics, where he wrote his Master Thesis on Local Currency Bonds in Emerging Markets. He holds a Bachelor’s degree in Economics from the University of Zurich, and is passionate about all facets of development economics.