Buttonwood
The end of the affair?Jan 25th 2005
From The Economist Global Agenda
SourceEmerging-market debt has been a sweetheart deal over the past three years. It is almost time to move onBUTTONWOOD having sensibly decided to go off and earn some real money, the search for his successor was long and arduous. The gene pool of those equally familiar with capital markets and Claire’s Accessories is not enormous, but the challenge was met. On detail, Buttonwood II is long dogs rather than cats and prefers four-hooved to four-wheeled transport; but she shares with her predecessor an interest in the high-yield end of the bond market—more specifically, emerging-market debt.
One spectacle that is always guaranteed to push up investors’ blood pressure is an Argentine government road show, and the current one is no exception. With some $81 billion (not counting unpaid interest) of the world’s biggest defaulted debt to swap, the country’s finance team is trotting its unappealing offer around the world, leaving bondholders howling. The proposed “haircut” remains somewhere north of 70%, depending on how you calculate it: US marine-like. So last week the Not The Argentine Road Show swung into action in London. Representing 30,000 investors holding $1.2 billion in debt, the Argentine Bond Restructuring Agency (ABRA)—part of a broader coalition—argues that Argentina could and should double its offer.
It could, but it won’t. The price of Argentina’s debt in the secondary market is around 32 cents (per dollar of debt outstanding), which suggests that this may in fact be what it is worth. Argentina’s public-relations skills are lamentable and its negotiating skills even worse, but its case is not without merit. Though the country’s economy grew by 8% last year and may see another 5% this year, output remains lower than in 1998. If the swap goes through, Argentina will still be left servicing a public debt equal to 80-90% of GDP, far more than Brazil, say.
Argentina says it will consider the swap a success if 50% of bondholders participate; the IMF (which, incidentally, is owed an additional $13.8 billion) wants 75%; the result will probably be between the two. Up to 40% of the debt is held by Argentines, for a start, and institutions there will settle. The professional, mainly foreign, investors who bought the bonds after default at 20 cents or so on the dollar will still make money after the haircut, especially if Argentine bonds move up in price as a result, which is likely. The sort of legal action that some bondholders are threatening is not promising, as recent judgments against Argentina in America have failed to produce a single seizeable asset. And a certain fatigue may be setting in, which the Bad Boy of the Pampas is counting on. The offer expires in mid-February.
The broader emerging-market debt story lies elsewhere, however, and it is very different. Brazil quietly raised a tidy ten-year €500m in euros, tightly priced, while Argentina was fighting with its creditors last week. For at least two years, with returns on Treasuries and other top-grade credits scant, investors have chased yield down every risky path, many of them far-flung. Now, however, investors may have to start going straight. Alan Greenspan warned in the Federal Reserve Open-Market Committee minutes published in January that he would know what to do if they didn’t. Some selling-off of riskier assets resulted. And analysts at securities firms, including Citigroup Smith Barney and Merrill Lynch, are writing that investors indeed feel more risk-averse than they did.
But there is nothing like a rout—in fact, quite the contrary. If forecasts by the Institute for International Finance (IIF), a Washington-based think-tank, are correct, private capital flows to emerging markets ($279 billion in 2004) will remain strong in 2005. True, much of that is direct investment, as opposed to the portfolio kind, and bound for the two “special cases”, China and Russia. But the IIF reckons that non-bank credit flows (mainly bonds) will fall back only $8 billion from their seven-year high last year of $65 billion. Other figures confirm the trend. Emerging Portfolio Fund Research, a firm based in Cambridge, Massachusetts, says that the emerging-market bond funds it tracks have seen solid net inflows for the past 12 weeks.
If investors are going off risk, why are they still keen on emerging markets? Many believe that these markets are not very risky any more. Most countries on J.P. Morgan’s EMBI+ (Emerging Markets Bond Index) are profiting from economic growth, high commodity prices, cheap money and broadly more sensible fiscal policies. A number are delinking from the dollar and diversifying the range of currencies in which they borrow (viz Brazil). They are also diversifying their sources of financing by raising more money in their domestic markets (Brazil again, and Mexico). The ratings agencies have rewarded many of them with upgrades. Over half of the issuers in the EMBI+ index now have investment-quality ratings.
There are other reasons, too, why emerging-market bonds continue to attract. Cash is sloshing around the system at the moment, and debt issuance has been fairly restrained. In certain markets (eg, China) investors are betting on a currency revaluation. But the basic reason is that investing in places like Ecuador, Thailand or Kazakhstan is no longer seen as taking a walk on the wild side. Accordingly, the spreads on emerging-market debt over Treasuries have come right down, as the chart shows.
But these tight spreads may not really be compensating investors for the extra risk, even if that risk looks reduced in the current economic conditions. Few expect big shocks from within the emerging markets themselves, though there are pockets of poor quality such as the Philippines, which wants to raise $1 billion this week. But there are many risks out there threatening not just high-yield markets but the whole investment climate: for a start, America’s twin deficits, the prospect of slowing world growth and the possibility of more corporate scandals shaking investors’ confidence.
The big question for high-yield debt is how soon and how sharply American interest rates move up, pulling investment into Treasuries and other low-risk securities and driving up yields generally. The consensus, reflected in current spreads, is that rates will rise gradually and emerging markets hold firm at least through the end of 2005.
But investors ignore the possibility of other kinds of bad news at their peril. Buttonwood II has lived in various exotic locations in recent years, and if there is one thing she knows, it is that most investors in New York and London haven’t a clue what companies and governments are up to in two-thirds of the globe. Transparency is not second nature east of Suez, or indeed south of the Rio Grande. The end of this particular affair should be anticipated.
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