Risks in Emerging Market Bonds
Learning Outcome
discuss risks faced by investors in emerging market fixed-income securities and the country risk analysis techniques used to evaluate emerging market economies
Emerging market debt was once nearly synonymous with crisis. The Latin American debt crisis of the 1980s involved bank loans but essentially triggered development of a market for emerging market bonds. In the early 1990s, the Mexican crisis occurred. In the late 1990s, there was the Asian crisis, followed by the Russian crisis, which contributed to the turmoil that sank the giant hedge fund Long-Term Capital Management. There have been other, more isolated, events, such as Argentina’s forced restructuring of its debt, but the emerging market bond market has grown, deepened, and matured. What started with only a few government issuers borrowing in hard currencies (from their perspective foreign, but widely used, currencies) has grown into a market in which corporations as well as governments issue in their local currencies and in hard currencies. The discussion here applies not just to emerging markets but also to what are known as “frontier” markets (when they are treated separately or as a subset of emerging markets).
Investing in emerging market debt involves all the same risks as investing in developed country debt, such as interest rate movements, currency movements, and potential defaults. In addition, it poses risks that are, although not entirely absent, less significant in developed markets. These risks fall roughly into two categories: (1) economic and (2) political and legal. A slightly different breakdown would be “ability to pay” and “willingness to pay.”
Before discussing these country risks, note that some countries that are labeled as emerging markets may in fact be healthy, prosperous economies with strong fundamentals. Likewise, the political and legal issues discussed in this section may or may not apply to any particular country. Furthermore, these risks will, in general, apply in varying degrees across countries. Emerging markets are widely recognized as a very heterogeneous group. It is up to the analyst to assess which considerations are relevant to a particular investment decision.
Economic Risks/Ability to Pay
Emerging market economies as a whole have characteristics that make them potentially more vulnerable to distress and hence less likely to be able to pay their debts on time or in full, such as the following:
Greater concentration of wealth and income; less diverse tax base
Greater dependence on specific industries, especially cyclical industries, such as commodities and agriculture; low potential for pricing power in world markets
Restrictions on trade, capital flows, and currency conversion
Poor fiscal controls and monetary discipline
Less educated and less skilled work force; poor or limited physical infrastructure; lower level of industrialization and technological sophistication
Reliance on foreign borrowing, often in hard currencies not their own
Small/less sophisticated financial markets and institutions
Susceptibility to capital flight; perceived vulnerability contributing to actual vulnerability
Although history is at best an imperfect guide to the future, the analyst should examine a country’s track record on critical issues. Have there been crises in the past? If so, how were they handled/resolved? Has the sovereign defaulted? Is there restructured debt? How have authorities responded to fiscal challenges? Is there inflation or currency instability?
The analyst should, of course, examine the health of the macroeconomy in some detail. A few indicative guidelines can be helpful. If there is one ratio that is most closely watched, it is the ratio of the fiscal deficit to GDP. Most emerging countries have deficits and perpetually struggle to reduce them. A persistent ratio above 4% is likely a cause for concern. A debt-to-GDP ratio exceeding 70%–80%, perhaps of only mild concern for a developed market, is a sign of vulnerability for an emerging market. A persistent annual real growth rate less than 4% suggests that an emerging market is catching up with more advanced economies only slowly, if at all, and per capita income might even be falling—a potential source of political stress. Persistent current account deficits greater than 4% of GDP probably indicate lack of competitiveness. Foreign debt greater than 50% of GDP or greater than 200% of current account receipts is also a sign of danger. Finally, foreign exchange reserves less than 100% of short-term debt is risky, whereas a ratio greater than 200% is ample. It must be emphasized that the numbers given here are merely suggestive of levels that may indicate a need for further scrutiny.
When all else fails, a country may need to call on external support mechanisms. Hence, the analyst should consider whether the country has access to support from the International Monetary Fund (IMF), the World Bank, or other international agencies.
Political and Legal Risks/Willingness to Pay
Investors in emerging market debt may be unable to enforce their claims or recover their investments. Weak property rights laws and weak enforcement of contract laws are clearly of concern in this regard. Inability to enforce seniority structures within private sector claims is one important example. The principle of sovereign immunity makes it very difficult to force a sovereign borrower to pay its debts. Confiscation of property, nationalization of companies, and corruption are also relevant hazards. Coalition governments may also pose political instability problems. Meanwhile, the imposition of capital controls or restrictions on currency conversion may make it difficult, or even impossible, to repatriate capital.
As with economic risks, history may provide some guidance with respect to the severity of political and legal risks. The following are some pertinent questions: Is there a history of nationalization, expropriation, or other violations of property rights? How have international disputes been resolved and under which legal jurisdiction? Has the integrity of the judicial system and process been questioned? Are political institutions stable? Are they recognized as legitimate and subject to reasonable checks and balances? Has the transfer of power been peaceful, orderly, and lawful? Does the political process give rise to fragile coalitions that collapse whenever events strain the initial compromises with respect to policy?
EXAMPLE 3
Emerging Market Bonds
Belvia has big aspirations. Although still a poor country, it has been growing rapidly, averaging 6% real and 10% nominal growth for the last five years. At the beginning of this period of growth, a centrist coalition gained a narrow majority over the authoritarian, fiscally irresponsible, anti-investor, anti-business party that had been in power for decades. The government has removed the old barriers to trade, including the signing of a regional free-trade agreement, and removed capital controls. Much of its growth has been fueled by investment in its dominant industry—natural resources—financed by debt and foreign direct investment flows. These policies have been popular with the business community, as has the relaxation of regulations affecting key constituencies. Meanwhile, to ensure that prosperity flows rapidly to the people, the government has allowed redistributive social payments to grow even faster than GDP, resulting in a large and rising fiscal deficit (5% of GDP this year, projected to be 7% in two years). The current account deficit is 8% of GDP. Despite the large current account deficit, the local currency has appreciated significantly since it was allowed to float two years ago. The government has just announced that it will issue a large 10-year local currency bond under Belvian law—the first issue of its kind in many years.
Despite a very strong relationship with the bank marketing the bond, Peter Valt has decided not to invest in it. When pressed for his reasoning, what risks is he likely to identify?
Solution:
There are several significant risks and warning signs. Coalition governments are often unstable, and the most likely alternative would appear to be a return to the previously dominant party that lacks fiscal discipline. That regime is likely to undo the recent pro-growth policies and might even disavow the debt, including this new bond. The bond will be governed by Belvian law, which, combined with the principle of sovereign immunity, will make it very difficult for foreigners to enforce their claims. In addition, the relaxation of regulations affecting key constituencies hints strongly at corruption and possibly at payoffs within the current regime. With respect to the economy, fiscal discipline remains poor, there is heavy reliance on a single industry, and the current account deficit is almost certainly unsustainable (e.g., over the 10-year life of this bond). In addition, the currency is very likely to be overvalued, which will both make it very difficult to broaden global competitiveness beyond natural resources and increase the investor’s risk of substantial currency losses.
ChatGPT Link - https://chat.openai.com/c/ccb9e626-d7e2-4e25-82be-93506abf1121
Last updated