Flight for quality? No! Flight for risk.
Low yields across the fixed income universe, in part the result of ultra-loose monetary policy from central banks, have encouraged investors to root around in unfamiliar territory, which has led to a so-called “flight for risk”.
Unholy EM trinity tempt investors with double-digit returns
By Elaine Moore
Argentina, Venezuela and Ukraine are the unholy trinity of emerging market debt, their double-digit returns tempting investors to ignore fears about civil war, crippling inflation and legal battles.
“You could call them the high yielders if you want to be more diplomatic,” says Stuart Culverhouse, an economist at London-based Exotix.
“But these are the countries that tick the box as basket cases. Their government bond yields flag up a higher probability of default, and they are large enough so that what happens to their debt payments can have repercussions.”
Financial markets are taking the risks seriously. Credit default swaps, a kind of insurance against governments failing to repay their debt, ascribe roughly a 50 per cent chance of Venezuela and Ukraine defaulting on their government bonds in the next five years. Argentina is given an even higher rate.
The conundrum, though, for investors who do not like the look of those odds is that disregarding yields of up to 12 per cent could prove a costly mistake.
“These countries all have the potential for default or restructuring – but they are paying huge risk premiums because of that,” says Peter Marber, head of emerging markets at Loomis Sayles, a leading US investor. “The high yields explain why investors – and not just dedicated emerging market players – are interested. But, maybe more importantly, the demand reflects how expensive other opportunities across the world are for bond investors.”
Low yields across the fixed income universe, in part the result of ultra-loose monetary policy from central banks, have encouraged investors to root around in unfamiliar territory, which has led to a so-called “flight for risk”.
“There is always an investor base with a mandate to look at distressed, high yield bonds, but these countries are seeing more crossover investors,” says Siobhan Morden, head of Latin American credit strategy at Jefferies. “One way to measure that is to look at the compression in the spread between emerging markets and high yielding corporate debt, which suggests a migration of investors to emerging markets.”
In some ways, high yielding emerging market debt might look a better bet than government bonds issued at lower yields, which reflect lower risk.
Indeed, the debt burdens of these countries look modest compared to those of countries on the eurozone’s crisis-hit periphery, some of which have recently been issuing debt at the lowest yields in the euro-era. Ukraine’s debts amounted to 42 per cent of gross domestic product at the end of 2013. Greece’s total debt levels, by contrast, were at a record 175 per cent of GDP.
However, it is not the stock of debt that is the problem but the issue of refinancing it. Venezuela, which faces several bonds maturing in the next few years, has avoided issuing debt in dollars at the current high price.
The country is also struggling with economic problems and social unrest. In February the annualised rate of inflation hit 57 per cent and scarcity of basic goods is at record levels, while street protests between pro- and anti-government supporters have left more than 40 people dead.
In Argentina, inflation is also creating problems and foreign reserves are being eaten away. But a more pressing cause for concern is the country’s history of defaulting on its debts.
Argentina remains adamant that it will not pay $1.4bn to a group of hedge funds led by Elliott Associates which refused to accept the terms of the default in 2001. A US court found in the hedge fund’s favour. The case is now in the appeal process, but there is a chance that it may erupt again soon and that Argentina may enter into a technical default.
Ukraine’s financial problems, so severe that the IMF agreed to a $17bn rescue package earlier this year, have been stoked by the crisis with Russia.
“The risk has switched from financial to geopolitical,” says Vadim Khramov, formerly of the IMF and now a chief economist for Ukraine at Bank of America Merrill Lynch. “Ukraine has always been running relatively low growth rates and high current account and fiscal deficits, but now the potential escalation of the internal conflict is the major risk to sustainable financing.”
Sovereign bond defaults are rare, says Richard House, emerging market bond manager at Standard Life Investments. But they do happen. Standard Life has positioned its emerging market bond funds away from Ukraine and Argentina after deciding that the yields do not compensate for the risks involved.
The question for investors, says Mr House, is whether they are under pressure to stick with a benchmark index and, if so, whether they will swallow their concerns and buy into the sovereign bonds of these countries – or try to find comparable yields from other sources in order to keep up.
“This is a real problem with indices in general, not just in emerging markets,” he says. “You’ll find that they can push investors towards taking greater risks than they may want to. |
