Download Introducing the Emerging Market Bond Index Plus

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Introducing the Emerging Markets Bond Index Plus (EMBI+)
•
The EMBI+, an extension of our EMBI, tracks all of the external-currency-denominated debt markets of the
emerging markets
• Well-defined liquidity criteria ensure that the index
provides a fair and replicable benchmark
• Daily historical levels are available from December 31, 1993
Overview
The J.P. Morgan Emerging Markets Bond Index
Plus (EMBI+) tracks total returns for traded
external debt instruments in the emerging markets.
Included in the index are U.S. dollar-and other
external-currency-denominated Brady bonds,
loans, Eurobonds, and local markets instruments.
Thus, the EMBI+ expands upon our EMBI, which
covers only Brady bonds, extending the market
benchmark to most strategic investment
opportunities readily available in the emerging
markets (see Exhibit 1).
The EMBI+ is the fourth in our family of
emerging markets indices. It covers the
external-currency debt markets. Our original
emerging markets index, the EMBI, covers only
Brady bonds and has more restrictive liquidity
criteria. The LEI, our Latin Eurobond index,
covers Eurobonds of over US$100 million in size,
but only from Latin America. Finally, the South
Africa Bond Index (SABI), our only
local-currency index, is completely separate from
all of the other indices.
In addition to serving as a benchmark, the EMBI+
provides investors with a definition of the market
for emerging markets external-currency debt, a list
of the traded instruments, and a compilation of
their terms. The EMBI+ currently includes 49
instruments from 14 countries, with a total face
value of US$175 billion and a market
capitalization of US$98 billion. This market
capitalization equals about 3% of the non-U.S.
portion of our world government bond index.
The EMBI and the EMBI+ are highly correlated
(.98), and thus their monthly returns are quite
similar (see Exhibit 3). Due to the added country diversification, the volatility of the EMBI+ is usually
lower than that of the EMBI. In the 18 months ending June 30,1995, the EMBI+ returned - 11.33% in
U.S. dollars.
Since the EMBI+ covers external-currency debt, we have defined emerging markets countries
according to the ability to repay external-currency-denominated debt and have chosen a credit ceiling of
BBB+/Baal. Corporates from these countries are also eligible, since rating agencies limit corporate
external-currency debt ratings to the country's sovereign credit ceiling.
In this publication, we describe the origins and history of the emerging markets, explain our methodology
for constructing the EMBI+, and analyze the index's current composition.
History
We include several asset types in the EMBI+: Brady bonds, loans (performing and nonperforming), U.S.
dollar local markets instruments, and Eurobonds. Brady bonds, which currently make up the largest
segment of the market, are bonds that have been restructured from defaulted commercial bank loans. The
loans in the index are of two types, defaulted loans awaiting a (Brady or other) restructuring and
performing loans, which trade more as bonds. Currently, the only U.S. dollar local markets instruments in
the EMBI+ are Argentine instruments. The last asset type, the Eurobonds, is the newest one, representing
the primary market for issuance by emerging markets countries.
Nonperforming loan market
Two of the asset types in the EMBI+, loans and Brady bonds, are structurally related. With the exception
of Russia Vneshekonombank loans, all of the nonperforming loans in the EMBI+ have been restructured
or are awaiting a restructuring into Brady bonds. These loans were either previously restructured loan
agreements or unstructured loans, pools of which were formed for the purpose of trading.
Trading of these loan pools among their original commercial bank creditors began to pick up around
1987. In 1988, Mexico conducted the first loans-for-bonds exchange, in which loans were exchanged for
discounted "Aztec" bonds, the first such securitization in the market. Later that year, Brazil restructured
some of its bank debt into par "Exit" bonds and negotiated new bank lending in the form of "New
Money" bonds. Although Mexico's and Brazil's arrangements preceded any formal Brady agreements, the
bonds that resulted were traded, along with Brady bonds, in the Brady market that formed two years later.
Brady bond market
The first formal Brady plan (named after former U.S. Treasury Secretary Nicholas Brady) was negotiated
by Mexico and implemented in March 1990. Although the details of subsequent Brady deals have
differed, they have largely followed the blueprint laid down by Mexico. Negotiations have usually
proceeded in tandem with a country's discussions with the IMF and other multilateral institutions. The
IMF's role has been to advise each country regarding economic policy in order to ensure that its economy
is healthy by the time of the exchange. The goal of past Brady plans has been to make the country's debt
more serviceable by lightening its debt load through both principal and/or interest forgiveness and longer
maturities. An added benefit has been the securitization of the loans into bonds, thus broadening the
investor universe and lowering future financing costs. The use of collateral, usually financed by the
multilateral agencies, has been intended to attract buyers by ensuring that principal and certain interest
payments would be made.
Negotiations over the terms of Brady agreements have typically centered around the "menu" of bond
options to be made available, the possible buyback of loans ahead of the exchange, the treatment of
interest arrears, and the timing of the exchange. All of these factors have weighed heavily on the prices
of the loans, since by the time of these negotiations a loan's price reflects the expected Brady terms.
The timing of the exchange has generally been set after the country has reached an agreement in principle
with the banks. Usually, a date when the underlying loans will cease trading has been set prior to the
exchange date, so that the interest arrears can be completely settled before the exchange. In some cases
(as with Brazilian MYDFA and Ecuadorian Consolidation loans), interest arrears have been partially
settled through the issuance of bonds before the formal Brady exchange date. In other cases, arrears have
been settled in cash at the time of the exchange.
In general, around the time each loan ceased trading, a market developed in when-, as-, and if-issued
(w/i) Brady bonds. Concurrently, in some cases a much less liquid market developed in loan
"participations." An investor buying a participation from an original holder of a loan typically received
the rights to any interim cash flows on the loan and to the bonds for which it was to be exchanged.
Finally, on the exchange settlement date, creditors and participants received the newly issued bonds, with
w/i trades settling the same day.
The menu of possible Brady bonds evolved with each new Brady agreement, as negotiations yielded new
instrument variations and types. Each bond type has been designed both to benefit the country in some
way (e.g., allowing principal reduction via discounted exchange, interest reduction via below-market
fixed coupons, or new lending) and to offer the investor something in return (e.g., collateral or market
interest rates). The earlier agreements, completed during the falling interest-rate environment of 1993-94,
saw an emphasis on fixed-rate bonds, while subsequent agreements have seen a shift to floating-rate
bonds.
For new investors, one of the most confusing aspects of the Brady market is the nomenclature, which has
developed along with its bonds. In many instances, similar types of bonds have been given different
names. For example, bonds issued for interest arrears have been named simply "PDI bonds" (Past Due
Interest bonds) but also "IDU bonds" (Interest Due and Unpaid bonds) and "EI bonds" (Eligible Interest
bonds), as well as “FRB bonds" (Floating-Rate bonds). A list of previous Brady agreements and their
resulting bonds can be found in Exhibit 4. (The specific terms and conditions of each bond are available
in the Emerging Markets Debt Directory, December 30, 1994. General information on the Brady market
can be found in The Brady Market, June 17, 1994.)
U.S. dollar local markets instruments
Currently, the only local markets bonds eligible for the EMBI+ are Argentine dollar bonds. The
Argentine domestic debt market comprises mainly restructured government obligations. Some of the
restructurings were voluntary, while others were compulsory. Like Brady bonds, all of the resulting
instruments have a perfect servicing record, regarding both principal and interest.
Argentine BONEX 89 bonds resulted from the compulsory exchange of large private time deposits for
Treasury-issued bonds as part of the country's 1989 Convertibility Plan. BOCONs (Bonos
Consolidationes) resulted from the consolidation and transformation of unpaid government debts into
bonds with 10-to-15-year tenors. Pensioner BOCONs originated from pension debts accrued in 1991 and
1992, and General Debt BOCONs from both debts to general suppliers and corporate tax-loss carry
forwards. Bonos del Tesoro (for example, the BOTE and BOTE II bonds) were part of another set of
public-sector restructurings. (For further information, see Argentina: domestic market overview, August
19, 1993.)
Russian Ministry of Finance bonds will become eligible for the EMBI+ when their settlement becomes
more transparent, preferably through Euroclear.
Performing loans
There is only one performing loan in the EMBI+, Moroccan Tranche A loans. Morocco restructured its
commercial bank loans in 1990, opting not to do a Brady exchange since the country was current on all
payments of these loans. This loan has a perfect servicing record.
Eurobonds
We use the term “Eurobond” here to include specially directed Eurobonds, such as Yankee bonds, and
Global Registered bonds. Eurobond issuance by countries that had previously rescheduled debt or (like
South Africa) had otherwise been excluded from private international capital markets is a relatively new
form of financing in the post-debt-crisis emerging markets. While restructured debt has resulted in a
concentration of creditors from within the group that originally held the defaulted loans - and has relied
on them to distribute the issues among a wider investor base - Eurobonds have been directed initially at a
wider range of investors. Also, unlike the Brady market in which the issue sizes are very large, the typical
Eurobond is $100 million or less in these countries. Issuance over $300 million is rare, with only a very
few "jumbo" ($1 billion) issues having been made. This dispersion of creditors and issues has tended to
lower the liquidity of individual issues, so that the actively traded set of Eurobonds is very limited.
The most actively traded Eurobonds tend to be large issues that trade in tandem with the Brady market.
Thus, the set of Eurobonds currently in the EMBI+ is very limited and, while fairly representing the
traded Eurobonds suitable for inclusion in an index, vastly underrepresents their total amount
outstanding. (Only issues from Argentina, Mexico, and South Africa, representing 6% of the total
emerging markets Eurobonds outstanding, are in the index at present.)
Methodology
In constructing the EMBI+, which dates from December 31, 1993, our objective was to create a
benchmark that would accurately and objectively reflect returns from price gains and interest income on
a "passive" portfolio of traded emerging markets debt. To do so, we adapted the methodology used
originally to construct our flagship index, the Emerging Markets Bond Index. The methodology required the
most adaptation when applied to loans, especially those that had undergone a conversion into Brady
bonds, included in the EMBI+; for these, an additional set of assumptions was necessary to determine
returns.
The EMBI+ is constructed as a "composite" of its four markets: Brady bonds, Eurobonds, U.S. dollar
local markets, and loans. These steps are followed in the construction:
1) A daily total return for each single instrument is computed.
2) For each market, an arithmetic, market-capitalization-weighted average of the daily total returns of the
constituent instruments is constructed.
3) An arithmetic, market-capitalization-weighted average of the four markets’ average daily total returns,
calculated above, is constructed. The result is a composite return for the overall EMBI+ market.
Single-instrument total return
The total return calculation for a single instrument is a means of representing the economic benefit of
holding the specific security. In its simplest form, it is based on the “cash in/cash out” notion—i.e., what
is paid for the security at the initial purchase and what is received at its sale. Of course, most fixed
income securities pay some form of coupon along the way (except in the special case of EMBI+
nonperforming loans), and some pay amortizations. For the calculation of total returns, this cash is
reinvested in the instrument when received.
Our treatment of loans requires a special set of
assumptions. Generally, the life of these loans had
three phases: (i) trading as a single loan or loan pool;
(ii) when it ceased trading as part of the loans-forbonds Brady exchange process; and (iii) once it
became a Brady Bond.
While a loan traded, we treated it much like a bond,
tracking its price movements and crediting it any
interest income paid. Once the loan ceased trading, its
value became a function of the return of the bonds
into which it would be exchanged. In some cases,
loan “participations” traded, allowing the investor, via
the loan creditor, to participate in any cash income
and then the ultimate loan-for-bond exchange.
Although this market was not active, we priced
“synthetic” participations via the actively traded when-, as-, and if-issued (w/i) market to determine the
loan's value during this period.
Once these w/i bonds were issued, the determination of total returns became more straightforward. The
EMBI+ takes into account all existing trading conventions, day-count bases, ex-periods, and multiple
series to give the most accurate reflection of changes in instrument value.
Market indices
Our means of calculating the total return on a basket containing various instruments is an extension of
our single-instrument framework. To hold a passive portfolio, one would buy the instruments in the same
proportions in which they are available for purchase. Each proportion is a function of both the amount
outstanding (which we will assume equals that portion of an asset's outstanding amount that an investor
can easily purchase) and its price. These two factors, when multiplied together, equal the asset's market
capitalization.
Index rebalancing is done on the last business day of each month, such that the next month's composition
reflects the changes. There are two kinds of "rebalancing events": changes to the list of included
instruments and active changes in the amounts outstanding. These events do not affect portfolio value.
When a rebalancing event occurs, it is as if the investor sells the entire portfolio at the day's closing (bid)
prices and then immediately reinvests the proceeds in the new portfolio in proportion to the new market
values based on the same (bid) prices. This results in a shift in the relative weights but not a change in the
overall portfolio value.
Composite indices
Composite indices are very similar to market indices, but at one level higher. Each market's daily return
is weighted by its market capitalization, and then these weighted returns are summed. This method allows
for cases in which one or more of the markets are closed while others are open.
For a full explanation of the methodology used to create the EMBI+, see the Emerging Markets Bond
Index Plus: Methodology, July 12,1995.
Choosing instruments for the EMBI+
Instruments in the EMBI+ must initially meet four eligibility criteria. First, an instrument must have a
minimum of US$500 million outstanding. Second, an instrument must meet a BBB+/Baal or below rating
requirement, designed to define "emerging markets" in the context of external debt markets. Third, the
instrument must have more than a year remaining to maturity. Fourth, the instrument must be able to
settle internationally, such as via Euroclear.
Once the eligibility requirements are met, liquidity criteria, similar to those used for the Emerging
Markets Bond Index, are applied to the instruments. Because our objective was to create a broader index
than the EMBI, we expanded the EMBI liquidity ratings, which are based on screen quotations and
bid/offer spreads, to include another, lower-liquidity rating (L5). With the addition of the new rating, we
have shifted all liquidity thresholds one level lower.
The five EMBI+ liquidity ratings are:
L1 Benchmark
L2 Active
L3 Traded
L4 Mostly illiquid
L5 Illiquid
Average bid/offer <3/8, and bond quoted1
by all designated brokers2
Average bid/offer <3/4, and bond quoted1
by at least half of designated brokers2
Average bid/offer < 2, and bond quoted1
by at least one designated broker2
Average bid/offer < 3. and bond quoted1
by at least one designated broker2
Bond rarely or never quoted by
designated brokers2
In addition, a plus sign (+) after a rating indicates that the three-month average rating is higher than the
current rating; a minus sign (-) indicates that the three-month average rating is lower than the current rating.
1A
bond is considered quoted in categories LI, L2 and L3 if it is priced 75% of the time; it is considered
quoted in category L4 if it is priced 25% of the time.
2
The list of designated brokers, which changes as the market develops, currently is: Eurobrokers, Tullets,
Tradition, Cantor, Chapdelaine, and RMJ.
We use these liquidity ratings to determine when instruments are added to or dropped from the EMBI+.
Instruments must be rated LI, L2 or L3 to be added to the EMBI+. Instruments are added in the first
month in which they achieve an Ll or L2 rating or in the third consecutive month in which they achieve
an L3 rating. Instruments must be rated L4 or L5 to be dropped from the index. Instruments are dropped
in the first month in which they fall to an L5 rating or in the third consecutive month in which they are
rated L4. However, if a bond is the last one in the EMBI+ to represent a given country, it is dropped in
the first month in which it falls to an L5 rating or in the sixth consecutive month in which it is rated L4.
To date, no instrument has been dropped as the result of an L5 rating. To further ensure stability of the
composition of the EMBI+, an instrument that has been dropped is not eligible to reenter the index for
six months, regardless of its liquidity rating.
Composition and weighting
As of June 30, 1995, the EMBI+ was primarily comprised of Brady bonds (80%); its Brady bond
subindex has increased in size overtime as loans have been converted into bonds. The EMBI+ is
concentrated in instruments from the three major Latin countries (68 %), reflecting the size and liquidity
of the Latin external debt markets. The smaller Latin countries bring the Latin portion of the index to
80%. At present, the non-Latin countries are mainly represented in the EMBI+ by Poland, Russia,
Nigeria, and the Philippines. A complete listing of instruments currently in the EMBI+ can be found in
Exhibit 6.
U.S. dollar issues currently make up more than 95 % of the index. The remainder is roughly divided
between Deutsche mark-and Swiss-franc-denominated Vneshekonombank loans in Russia. Similarly,
sovereign issues make up 98 % of the index, which currently includes only two corporates, both from
Mexico.
While only 8 of the 49 issues in the EMBI* have an Ll liquidity rating, they represent 41 % of the market
value of the index, clearly demonstrating the connection between size and liquidity. Nineteen issues
representing 35% of the index have an L2 rating, while the remainder have L3 ratings. In most cases,
instruments rated L3 are either not Brady bonds or are Brady bonds with face outstandings; of under $1
billion.
Index summary
EMBI Q&As
What is the EMBI?
The J.P. Morgan Emerging Markets Bond Index (EMBI) is a total-return index tracking the traded market
for U.S.-dollar-denominated Brady bonds. As
of October 30, 1998 the EMBI includes 29
issues, with a total face value of $113.1
billion and a market capitalization of $73.7
billion. Historical data starts on December 31,
1990.
What countries are included in the EMBI?
The EMBI currently includes 10 countries:
Argentina, Brazil, Bulgaria, Ecuador, Mexico,
Panama, Peru, Poland, Russia, and Venezuela.
How is the EMBI related to the EMBI+?
The EMBI, which covers Brady-style issues
only, is a subset of the EMBI+. The EMB+,
which we back-built to December 31, 1993,
includes Brady bonds, Eurobonds, loans and
U.S.-dollar-denominated domestic debt. However, the EMBI and the EMBI+ are highly correlated (0.98).
As of October 30,1998, the EMBI compromised 61.6% of the EMBI+ by market capitalization. In terms
of country diversification, the current inclusion of the Morocco, Nigeria, and South Korea in the EMBI+
is the most significant difference between the two indices.
How do we determine the EMBI country weights and total returns?
The EMBI is market capitalization weighted, based on publicly stated face amounts outstanding.
Individual bond returns are calculated based on daily changes in bid prices and interest earned according
to coupon accrual and payment conventions. Total returns are calculated by weighting the bonds' daily
returns in proportion to their market capitalization.
When do EMBI rebalancings and composition changes occur?
Rebalancing, done on the last business day of each month, is only required in either of two cases: (1)
when issues are added to or dropped from the index, or (2) when a government augments the outstanding
amount of a bond or repurchases part of it, thereby canceling a portion of the outstanding issue.
What are the criteria for adding and dropping instruments?
Instruments must have a minimum face amount outstanding of $500 million and must be available and
liquid. Our liquidity ratings have been established based on three objective indicators: a bond's face
amount outstanding, its average bid/ask spread, and the number of designated brokers quoting it. (For
definitions of our liquidity ratings, please see EMBI+/EMBI rules for adding and dropping issues,
September 30, 1998.) Bonds must be rated L3 or better to be added to the EMBI, and L4 or lower to be
dropped. Bonds are added in the first month in which they achieve an L I rating, in the third consecutive
month in which they achieve an L2 or better rating, or in the sixth consecutive month in which they
achieve an L3 or better rating. Bonds are dropped in the first month in which they fall to an L5 rating or
in the sixth consecutive month in which they are rated L4.
How has the EMBI performed?
The average annualized return of the EMBI since its inception on December 31, 1990, has been 14.97%.
Annual returns are shown in Exhibit 2.
Where can EMBI results be found?
Daily EMBI results can be found using the following sources:
Bloomberg (type: JPMX <GO>), Reuters (pages: EMBIO 1,
EMBI04), Telerate (pages: 1787, 1763), and J.P. Morgan's Web
site (address: wwwjpmorgan.com). Results are published in our
monthly Emerging Markets Bond Index Monitor and weekly
Emerging Markets Analytics.
Additional information is available upon request. Information herein is believed to be reliable, but J.P. Morgan does
not warrant. Its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to
change without notice. Past performance is not indicative of future results. This material is not intended as an offer
or solicitation for the purchase or sale of any financial instrument. J.P. Morgan may hold a position or act as market
maker. In the financial instruments of any issuer discussed herein or act as advisor or lender to such issuer. J.P.
Morgan Securities Inc. Is a member of NASD, SIPC, and SFA. Copyright 1998 J.P. Morgan & Co. Incorporated.
Clients should contact analysts at and execute transactions through a J.P. Morgan entity in their home jurisdiction
unless governing law permits otherwise.