What to do in the bond rally

Global bonds

Posted by Pinto (Thursday, March 14, 2002)
What to do in the bond rally

by Paul Luke
+46 8 50 68 78 43
paul.luke@brunswick-em.com

What to do in the bond rally

So the scene is set for a virtuous circle of lower yields and higher equity multiples in emerging markets in 2002/2003, akin to that seen ten years ago. Liquidity, after all, abounds. However, the fact that bond yields are set to decline further does not mean that there are not pitfalls to avoid and/or strategies to pursue. I may come back to corporate and toxic end of the market in a future newsletter, but, in the meantime, here are <<Luke’s five laws>>of successful sovereign bond management.

First, refuse low spreads. As I argued two weeks ago, anyone who buys a ten-year Polish bond at 71 basis points over has got to have their head examined. Poland has not got its act together economically or politically, MSCI EMF whatever the prospects for European Union membership. The risks are not rewarded by a nugatory 71 basis points, even though Poland is a BBB+/ Baa1 credit. Give me ten year Mexico (BBB-/Baa3) at 233 basis points any dia de la semana.

Secondly, reduce Russia and increase exposure to Brazil. The chart compares the recent path of yields on Russian and Brazilian bonds. Russia has traded through Brazil, despite the fact that Russia has a big bunching of maturities in 2003. Even if the spread differential stays the same, a 100 basis points fall in Brazilian spreads will produce a bigger capital appreciation than a 100 basis points fall in Russian spreads. Brazil is going to come out of this week’s Inter-American Development Bank annual meetings smelling of roses and ready to borrow more money to buy back more debt, despite the current political spat.

Thirdly, avoid countries with high debts and a fixed exchange rate. Bulgaria’s 2007 Euro-denominated eurobond trades at 207 basis points over EU bonds. The country has failed to get inflation down to EU levels and fixes its currency against the euro. Bulgaria will probably be OK, but they were saying that about Argentina a while back. At 207 basis points of spread, the risk-reward is all wrong.

Fourthly, overweight Venezuela and countries with strong balance sheets. One of the best emerging debt fund managers in the world calls the yield on Venezuelan the “Latin American risk free rate”. This may be a slight exaggeration, but the country is under-indebted relative to its assets and runs a public sector foreign exchange surplus (oil revenues exceed interest payments). Unlike most countries, a decline in the exchange rate helps improve public sector credit-worthiness. This is why the country’s bonds jumped last month on the day the bolivar was left to float unaided. Its external debt is falling as it pays down its Brady debt (see below for explanation of the term “Brady”). I have been watching this country’s economic and political fortunes gyrate for over twelve years, but they keep paying.

Finally, where possible, buy collateralised Brady bonds and lever the collateral. Brady bonds are long-dated bonds issued in lieu of bank debt in the wake of the 1980s debt crisis. Many of them are collateralised as to principal by US Treasury paper and carry a rolling interest guarantee. When you strip out the collateral from your yield calculation, what remains is far higher yielding that plain vanilla eurobonds. For example, the Brazilian Brady discount bond of 2024 trades at 75% of face value. That price contains 35 % of basically risk-free collateral and 40% of Brazilian risk. This Brazilian risk component has a yield of 14.3%. The Brazilian global bond of 2024 trades with a yield of 12.7% to maturity. It is impossible to strip the collateral out of the bond, but you can get near the effect by leveraging the collateral or selling Treasuries against it.

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04-22-02 manya: Moody's says global bond defaults reach record in Q1 2002

(The following statement was released by the rating agency)

LONDON, April 22 - Moody's Investors Service said today that bond defaults hit an all-time quarterly record $34 billion in the first period of 2002, although the global speculative grade bond default rate fell for a second consecutive month in March to 10.3%. By the end of the year, Moody's forecasts a default rate of 7.4%.

The global speculative grade default rate fell in February for the first time since October 2000 when the rate dropped from January's 10.7% to 10.5%. However, despite a lower default rate, default volumes posted a quarterly record. The higher than expected default rate resulted from a quarter that saw high default activity in terms of dollar volumes, but a lower number of defaults relative to year-ago levels. In the first quarter of 2002, 47 issuers defaulted on a total of $34 billion of bonds - the most severe quarter for defaults on record in terms of dollar volume. In the first quarter of 2001, 55 issuers defaulted on $29.2 billion of bonds. Among US-based corporate bond issuers, the first quarter saw 32 defaults ($22.6 billion). The US-only speculative- grade default rate rose 10 basis points to 11.3% in March from 11.2% in February.

The speculative-grade default rate for non-US issuers fell to 8% from 9%, as 15 corporate bond issuers located outside the US defaulted on $11.4 billion. The size of defaults in the first quarter was indeed large. The top five largest defaults represented 50% of the total dollar volume in the first quarter. The largest defaulters were led by UK-based United Pan-Europe Communications N.V., which defaulted on $5.1 billion of bonds. Other large defaults included Global Crossing Holdings Limited ($3.8 billion), McleodUSA, Inc. ($2.9 billion), Metromedia Fiber Network, Inc. ($2.6 billion), and Kmart Corporation ($2.4 billion). The sheer size of defaults has skewed some of the statistics and the perception of default risk. The average size of default in the first quarter 2002 was $722 million. The median size of default was a much lower $262 million. "Default risk actually feels worse than it really is because recent defaults have been so large in terms of dollar volume and because a few well-known names have gotten into trouble," said David T. Hamilton, Director of Default Research.

Default rates are constructed in many different ways by academics and practitioners. Default rates measured by dollar volume are appropriate for measuring the portfolio impact of defaults. Issuer-weighted default rates, such as Moody's statistics, are more suitable for measuring the probability of default. Moody's trailing 12-month global speculative grade default rate is an issuer-weighted statistic that includes only issuers that have held a speculative-grade rating (Ba1 and below) for at least a year before default. Volume-weighted and issuer-weighted default rates tend to have the same long-run trend, but can and have diverged in the past when the volume-size per issuer of defaults has departed significantly from the average. In the third quarter 1999, for example, Moody's volume-weighted default rate rose sharply, far outpacing a modest rise in the issuer-weighted default rate when Iridium filed for bankruptcy. A divergence in the two series is not contradictory, but just communicates different information. Default volumes are likely to remain high in the short run, particularly in the month of April. NTL Communications Corp.'s proposed debt exchange includes a minimum of $8.4 billion of bonds, and Williams Communications Group's default totals $3 billion.

Nevertheless, Moody's expects the number of issuer defaults to decline. Moody's is forecasting a 7.4% default rate by year's end and a 6.6% default rate for the 12 months ending March 2003. "Virtually every indicator that is useful for predicting the default rate points to lower levels a year from now," Hamilton said, citing healthier industrial production figures, continued low interest rates and a steep yield curve, a tightening high yield spread, and improving credit fundamentals. Although the default rate statistic is subject to short-run volatility, Moody's believes that the default rate is peaking, with lower default rates expected in the second quarter and throughout the remainder of 2002. For global speculative grade issuers that means that January's 10.7% default rate represents the cyclical peak. For US-based spec-grade issuers, the default rate peak is likely to be near its current level of 11.3%. Moody's also continues to monitor the situation of corporate bond issuers in Argentina, which still present a significant near-term risk of default. To date, only 7 ($4.2 billion) rated corporate bond issuers have defaulted in Argentina. Moody's is making its determination of default for Argentinean corporate issuers on a case-by-case basis. Argentina's central bank has indicated that special dispensation can be granted at its discretion to corporate issuers to make external payments. In Moody's view, the imposition of capital controls in and of itself has not precipitated de facto default status on all Argentinean rated corporate bond issuers eligible for inclusion in the default rate, which number 24.

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