Emerging-markets debt is alive and well in fixed-income markets, which operate on the belief that it’s worth taking on risk to beat continuing low interest rates in the developed economies. In the hierarchy of global sovereign debt, the lowest rungs are the governments of the developing economies. Yet, those are the issuers whose bonds are getting a lot more respect these days.
Mexico, which is in the upper tier of emerging markets, saw its sovereign bonds issued at the end of 2013 rated BBB+ by Standard & Poor’s Financial Services LLC (S&P). In January, Mexico took advantage of its ascent into middling investment-grade status by offering a US$1-billion, seven-year federal bond issue priced to yield 3.61% to maturity, the lowest rate ever for a Mexico federal bond priced in U.S. dollars (US$).
Two weeks later, Colombia sold a US$2-billion 30-year bond issue to yield 5.647% to maturity, the lowest rate that country has ever had to pay.
Behind bond investors’ push into emerging-markets bonds is the persistent low interest rate environment in the U.S., Canada, the U.K. and the eurozone. Calling widespread stagnation “the new normal,” American economist and blogger Taegan Goddard makes the point that with equities markets highly priced because of growth and senior bond markets highly priced because of lack of growth, investors are desperately seeking alternatives in the Third World. Much of this market is global junk debt, but it comes with huge yield boosts over G7 bonds.
Even shaky markets appear to be headed toward normality.
In mid-April, an offering of Greece’s federal five-year bonds priced to yield 4.99% to maturity, the lowest level since May 2010, was heavily oversubscribed.
And Italy’s 10-year sovereigns now pay just 3.3%, which is 62 basis points (bps) over 10-year U.S. treasuries, which pay 2.68% to maturity.
Three years ago, in the midst of the “PIIGS” – Portugal, Ireland, Italy, Greece and Spain – crisis, Italy’s bonds were paying 7% and Greece’s bonds carried 40% yields. But normalcy has returned to PIIGS bonds. The average yield to maturity on bonds from all five countries was just 2.23% on April 25, according to Bank of America Merrill Lynch indices. That’s a 75% decline from the index rate of 9.55% at the height of the crisis in 2011-12.
The European monetary crisis has moved from critical to chronic. So, bond investors who want to spice up their portfolios are adding risk. The return of the PIIGS to bond market respectability and lower yields has driven yield-hungry investors farther afield.
For example, Indonesia raised the equivalent of US$1 billion in its native currency, the rupiah, on March 4 with annualized yields of 8.599% for an issue maturing in March 2020 and of 9.044% for bonds maturing in February 2044. These issues were heavily oversubscribed, according to a local English-language newspaper, the Jakarta Globe.
And with good reason, says Marco Santamaria, portfolio manager specializing in emerging-markets bonds with money manager AllianceBernstein LP in New York: both Moody’s Investors Service Inc. and S&P rate Indonesia’s debt just below the borderline between investment-grade and high-yield. Thus, the recent bond issues are attractive, Santamaria says, with yield spreads of 625 bps over U.S. 30-year treasuries.
It’s a good yield for the risk, Santamaria notes: “You could get those returns from the domestic U.S. high-yield market. But to do it, you would have to go deep into junk territory.”
(The currency risk of trading in and out of the rupiah is another matter.)
Indonesia has settled down into the mid-tier of emerging markets, with no recent revolutions, civil wars or defaults.
Yet, the bond market has a short memory. Rwanda, for example, which was racked by genocide and civil war two decades ago, now gets a good reception for its sovereign debt.
A recent issue of bonds from the National Bank of Rwanda paid annualized rates of 5.9% for 91 days and of 6.56% for 182 days. The bet, of course, is that the bonds will not default in either period. For taking what seems modest default risk, the investor gets a 502-bps boost over the 0.88% return on three-month Government of Canada treasury bills and a 567 bps lift over the 0.89% yield on the six-month Canada, respectively.
There is the overhanging problem of default. In financial markets, the developing world is characterized by it. Among the worst offenders are Angola, in default for 59% of the years since independence; the Central African Republic, which has been in default on its bonds 53% of the years since its independence; and Ivory Coast, in default 49% of years since independence.
Greece leads Europe in the default category, with defaults in the mid-50% (current issues are still being worked out).
In Latin America, Honduras gets the prize, with defaults in 64% of the years since its independence.
These percentages illustrate the risk of venturing into lands in which, for sovereign debt, there are no meaningful insolvency procedures, Santamaria notes. It is tough to collect from a deadbeat with an army.
“The rates are attractive,” says Adrian Mastracci, president of KCM Wealth Management Inc. in Vancouver. “But if a client wants to buy into this market, it has to be diversified over many countries.”
A mutual fund is one way to do it, he adds: “For the risk, for the exchange issues when bonds are in local currencies and for the need to watch these markets closely, active [portfolio] managers earn their fees. Most of all, a client should have no more than a small fraction – say, 5% of total invested capital – in these exotic funds.”
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