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WORLD / AMERICAS

Can Colombias bond market keep its new


friends from overseas?
Jacopo Dettoni | 1/08/2017 9:00 am

Foreign demand for Colombias peso-denominated bonds has been a boon for a country struggling with
low commodity prices. But for how long will market condence stay high? Jacopo Dettoni reports.

Colombias push for peace, reforms and an economic life beyond oil, combined with the pesos renewed
signs of vitality in the currency market, has shored up foreign demand of its peso-denominated debt
notes, known as TESs, over the past two years. Almost untouched by investors outside the country only a
few years ago, foreign holdings of Colombian bonds spiked up to more than one-quarter of total
outstanding TES notes, as shown by the latest gures from the country's nance ministry.

US-based asset management powerhouse Franklin Templeton led the charge, accounting for half of the
foreign demand for TES bonds in 2016. If growing inows of portfolio investment helped the government
support ongoing scal and current account adjustments, they also increased the pressure on the
Colombian authorities to deliver on key issues such as scal discipline and a promised peace dividend
following congressional approval of the historic peace deal with leftist rebel group Farc in December
2016.
It all means that we have to [take care of ] the economy, says central bank governor Juan Jos Echevarra.
If that doesnt happen, this capital will leave the country.

A buying spree

Unlike Colombian shares, which continue to be hampered by low liquidity, TESs stand out at the heart of
a dynamic domestic xed-income market with an increasingly diverse base of participants. Foreign
holdings of TESs grew to 64,083.7bn pesos ($20.8bn), or 26.2% of total outstanding TESs, at the end of
May 2017, twice as many as the 32,206.3bn pesos (15.6% of the total outstanding TESs) of June 2015,
nance ministry gures show. Only as recently as 2012 they failed to reach 2.5%.

Franklin Templeton alone, which started adding Colombian local currency bonds in early 2016, acquired
TESs for 10,000bn pesos in the full year, making up 48% of the foreign demand and becoming the largest
single foreign investor in TES notes, according to gures from local asset manager Alianza Fiduciaria.
Other major investment names such as BlackRock, Pictet, Allianz and Aviva followed suit. Overall, foreign
purchases rose to a record 21,000bn pesos in 2016, absorbing two-thirds of the new TES notes issued in
2016.

Now that Colombia has reached a peace accord after 50 years of civil war, the country can unlock a lot of
its economic potential, says Michael Hasenstab, executive vice-president and chief investment ocer at
Templeton Global Macro.It will be able to raise living standards through increased investment,
particularly in infrastructure. Improving the power and transport sectors can signicantly reduce supply
bottlenecks and cut the costs of goods.

Though not without hiccups, such as failing to secure a majority in a referendum held in October to
uphold the peace agreements struck between president Juan Manuel Santos and Farc, the countrys
commitment to the peace process culminated at the end of 2016 with congressional approval of the
revised peace agreement. The International Monetary Fund estimates a peace dividend in the order of
0.5% of extra annual growth in the near term, which at least partially balances the loss of economic
potential stemming from the end of the commodity boom. Medium-term economic potential is now rated
at between 3% and 3.5%, below the average annual growth of 4.6% achieved amid very favourable
external conditions between 2006 and 2015, but higher than the 2% achieved in 2016.

Institutional strength

Taking the long view, foreign investors are factoring in the quality of todays Colombian institutions and
their constant push towards reforms. It was scal reform that put Colombia on the map for foreign asset
managers in the rst place in 2013, when the nance ministry slashed the tax rate on capital gains on
xed-income trades from 34% to 14%.

The Colombian sovereign debt market was already relatively big and liquid, but foreigners did not have
access to it because yield after taxes was not attractive, Juan Pablo Cordoba, CEO of the Colombian Stock
Exchange, said at the Colombia Inside Out investment roadshow in London in June. Slashing the tax
rate to 14% made a real difference.

These improvements in the regulatory environment caught the attention of JPMorgan, which began to
increase the weight of Colombian debt notes in its Government Bond Index-Emerging Markets (GBI-
EM) indices, a major benchmark for investors in emerging markets xed-income area, as a result of
improved transparency and accessibility for international investors in the local TES market.

The central bank also played a key role in boosting the markets credibility by sticking to its ination-
targeting approach, even in more recent times of severe economic slowdown.
Colombias central bank has kept the country on track by tightening rates during much of 2016 to rein
back ination, says Mr Hasenstab. Interest rates rose by 300 basis points between 2015 and the rst half
of 2016.

That combination of sound scal and monetary governance combined with the start of a peace era, on
top of already resilient growth, is creating an optimal investment opportunity, adds Mr Hasenstab.

The hike in interest rates prompted the pesos recovery. The Colombian currency rose about 13% against
the US dollar after touching a historic low in February 2016, giving the TES market new momentum.

From the beginning of 2016 through [to] April this year we did see substantial currency appreciation [in
Colombia] and that adds to the total return you can get in bonds [in dollar terms], says Jan Dehn, head
of research at Ashmore Investment Management.

Adjustment needed

However, that phase is coming to an end as other economies in the region become more appealing.
International enthusiasm for Colombias peace deal is likely to fade, opening up potential concerns over
macroeconomic imbalances.

Today, we dont see Colombia as particularly attractive in peso bonds compared with other destinations in
Latin America, saysMr Dehn. I think that investors are slowly beginning to realise the story of the whole
[president Juan Manuel] Santos era is coming to an end. Right now we are more bullish on private, off-
market opportunities than bonds.

Mounting foreign interest has pushed up TES valuation, with 10-year yields falling from more than 9% in
February 2016 to 6.7% in the rst week of July 2017. Today, investors can nd better yields from Latin
American local currency sovereign bonds in Mexico, Brazil and Argentina. The latter two are not
investment grade, however.

At the same time, the market is becoming increasingly aware of Colombias need for further adjustments,
rst and foremost on the scal side.

Last years scal reform helped bridge the nancing gap in 2017 and 2018, but there will be either
expenditure cuts to be made, or additional revenues to be found in the future, says Samar Maziad, senior
analyst at credit rating agency Moodys, which has a Baa2 rating with 'stable' outlook on TES notes.
Standard & Poors and Fitch both have a BBB rating with a 'negative' outlook.

The end of the bonanza petrolera, or oil boom, took a heavy toll on Colombias nances, drying up oil-
related scal revenues worth up to 4% of gross domestic product almost overnight in what nance
minister Mauricio Crdenas called the worst scal shock in our history. A major reform was passed in
December to raise billions in the coming years and make up for lost oil revenues. However well-received
initially, the authorities soon realised that the reform would fall short in achieving the targets set by a
scal rule adopted in 2011 aimed at shrinking the decit to 1% by 2022.

In to stay?

While Colombia waits for new adjustments to materialise, foreign portfolio investment has played a key
role in supporting an initial rebalancing of the countrys scal and current account decits. With yields
down from 2016 levels, they will not match last years record levels of TES purchases, but are not expected
to pose a capital ight risk for the country.
Foreign investors will play a more regular role in the TES market in Colombia and we are seeing slower
foreign demand this year, says Felipe Campos Salazar, head of strategy and research at Alianza Fiduciaria.
We have already done a catch-up and from now on foreign holdings will grow to 35% of outstanding
TESs in the good times, and fall to 20% in the bad times, but I dont believe we will see oscillations
beyond this range.

Leading investor Franklin Templeton has in the past unwound its exposure to other emerging market
sovereign debt gradually over a period of about three years, suggesting a limited risk of a sudden sell-off of
its TES portfolio, according to an analysis by Alianza Fiduciaria.

We have already seen a lot of capital ight from emerging markets associated with the [US Federal
Reserve] taper, says Ashmores Mr Dehn. Foreigners invested in Colombia right now are dedicated
emerging markets guys. They are fairly comfortable about Colombia.

This is reassuring, but with presidential elections due in 2018 and Juan Manuel Santos stepping down
after winning two consecutive mandates, Colombias new leader will have to consolidate ongoing efforts to
achieve peace and reboot the economy and state nances. Foreign bondholders will likely maintain their
trust in Colombian institutions, alongside their concerns over macroeconomic adjustments. Their growing
share of TES bonds makes them a group of stakeholders any new president could not ignore.

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