Global government bonds have had a terrific year. But while the Citigroup world government bond index was up by 11% in U.S. dollars terms for the year ended Dec. 31, 2008, not every sovereign credit was a winner. At the end of the year, Ecuador defaulted on its sovereign US$-denominated bonds — once again raising the question of the wisdom of investing in emerging markets’ government bonds.

Citing numerous inconsistencies in bond documents, Ecuador decided not to pay out on three series of bonds on which coupon payments were due. Bloomberg LP reported on Dec. 15, 2008, that Ecuadorian president Rafael Correa called the US$3.9-billion debt “illegitimate.” The bonds had fallen to US25¢ per US$1 of face value in trading on the eve of the default.

Ecuador is hardly the first emerging market to default. A survey by Standard & Poor’s Corp. covering 1975-1999 showed that 69 of 113 bond-issuing countries had defaulted on their foreign-currency debt.

The governments that had defaulted — including Angola, Argentina, Brazil, Ghana, Vietnam, Russia, Uruguay and Venezuela — had been able to make a case for not paying out on their foreign-currency bonds and all skipped out on their debts, although some were able to reschedule payments, usually on terms that were oppressive.

Ecuador’s case is fascinating. It shows how serial defaulters work and raises the question of why anyone would throw money at them.

The most recent default is the country’s second in a decade and the seventh in Ecuador’s 178-year history as a nation. In 1999, Ecuador halted payments on US$6.5 billion of bonds that had been restructured just five years earlier. At that time, Ecuador decided to pay holders US60¢ on the dollar, which was generous compared to the US30¢ on the dollar that Argentina paid bondholders in 2005 on a US$81-billion default in 2001. Argentina is still in litigation on that default and has been frozen out of global capital markets.

The recent Ecuadorian default has happened for political reasons rather than lack of cash, says Patrick Esteruelas, a Latin American bond analyst with the Eurasia Group, a political-risk consulting firm based in New York that focuses on emerging markets. Unlike Argentina, which had debt equal to 150% of its gross domestic product, Ecuador’s debt represents just 20% of its GDP. But President Correa and his government decided that they would prefer not to pay, citing various reasons, including the lack of a signature by a government official on one document, a 30,000-page report (lengthy enough to hold about 40 novels the length of War and Peace) that was probably intended not to be read.

The question for investors who researched the bonds is why they gave money to a nation that has never, according to Esteruelas, paid out on a bond to its maturity. Moreover, Ecuador does not even want to hear from international bankers. Recently, it has thrown out representatives of the World Bank and the Inter-American Develop-ment Bank, each of which was trying to help the country avoid default. Holders of Ecuadorian debt cannot be optimistic about getting their money back.

This article would be about financial masochism, were it not for some reasonable basis for buying bonds from serial defaulters. That rational basis exists because most global bonds don’t default. The ones that do run into trouble tend to come to market when their respective nations are having a period of good growth or are paying down existing debt, or have a new government committed to behaving well in global bond markets. When those conditions change, defaults can happen.

But research can give early warning and help investors dump bad credits. Moreover, global bonds, even those expected to default, can be actively traded between optimists willing to pay more and pessimists eager to get out at any price.

With 10-year U.S. Treasury bonds priced to yield 2.5% a year to maturity and Government of Canada 10-year bonds paying 2.9% a year to maturity, the appeal of emerging-markets bonds that offer a net return of 9.18% a year to maturity is evident — especially when compared with the 7.5% average yield to maturity on all U.S. investment-grade corporates.

So, is the yield boost obtained on sovereign risk worth it? Not on the surface, says David Rolley, co-head of global fixed-income with Loomis Sayles & Co. LP in Boston. “At the benchmark level,” he says, “sovereign debt in hard currencies will beat U.S. treasuries next year, although U.S. corporates adjusted for defaults are likely to beat global sovereigns.”

@page_break@That tilts the market toward corporates. Holders of defaulted corporate debt can seize assets, something bondholders cannot do with a foreign country.

“Every story from a bond issuer that has defaulted in the past is unique to its particular history and circumstance,” Rolley adds. “It is possible for the leopard to change its spots. For example, Mexico, which became independent from Spain in 1821, defaulted on its bonds by 1828. It has had several other defaults, but Mexican public finance has been exemplary in the past 20 years. [Mexico] had a solvency crisis in 1994 and it solved it. Now, its U.S. bonds and peso bonds are investment-grade. Mexico’s long-dated bonds are priced at 325 basis points over U.S. Treasury bonds of the same term, which is about the same as a BBB-rated US$ corporate bond.”

To consider bonds from countries that have a record of defaults, a client needs to have good research and a strong stomach. “Many of these issuers seem to operate on the P.T. Barnum principle that ‘there’s a sucker born every minute’,” says Randy LeClair, senior vice president and portfolio manager with AIC Ltd. in Burlington, Ont. Yet, well-advised and quite competent institutions do buy and trade emerging markets’ debt.

The reasons are all about the price. “If emerging-markets bonds are priced to default and they actually pay on time, they can double overnight,” Rolley says. “Then, the benchmark that holds these bonds does well. If you are running an emerging-markets bond fund, you’ll look bad and underperform. So, that’s one reason for holding them. And prior to default, active trading can generate handsome profits for sophisticated players.”

The bottom line is that for buy-and-hold clients, edgy global bonds will always be nail-biters. This is one market that’s either best left to the pros or best accessed via global bond funds run by money managers who can dodge defaults. IE