Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 220

Bond demand is dumb, dumber and dumbest

One of the classic signs that the strong credit cycle is nearing its end is that borrowers that should not be getting financed are not only raising money, but doing so on terms that seem crazy. I have recently written about the silly things happening in global high yield debt, Chinese debt and the global attitude to sovereign debt. Continuing this theme are recent examples of emerging market sovereign debt in Greece, Argentina and Iraq. Each of these should not have been funded, but the desperation for yield saw all three achieve crazy funding levels. Here are the details to show how investors have gone mad.

Argentina

In June, Argentina sold $2.75 billion of US dollar denominated 100-year bonds at a yield of 7.92%. This was a mere 5.18% yield pick-up over 30-year US Treasuries. Argentina has a long history of defaulting on its government debt, including four defaults in the last 35 years. The 2001 default took 15 years of negotiation and litigation to resolve, with most bondholders losing their shirts and a few who bought late and fought hard achieving extraordinary returns.

The current outlook shows that not much has changed for Argentina. Inflation is running at over 20% and the government is aiming to cut the deficit this year to 4.2% of GDP, hoping to stimulate the economy out of recession. Investors are banking on the recent change in government to increase foreign investment and see sound economic management implemented. The need to reduce politically popular subsidies will be a major hurdle to that plan. S&P’s rating of “B” and Moody’s at “B3” reflect the country’s weak credit profile. Taking all of this into account, Argentina is unlikely to get through a decade without defaulting, let alone 100 years.

Greece

In July, Greece sold €3 billion of five-year bonds at 4.63%, a 4.78% yield pick-up relative to five-year German government bonds. Investors have particularly short memories on Greece’s sovereign debt, with the 2012 default seeing bondholders take losses of around 75%. The 2014 issue of five-year bonds traded as low as 56% of face value, a horrible ride for those who bought into it. The constant negotiations for further bailouts always come with the threat that Greece will not make further concessions and this time the Europeans and the IMF might have had enough.

Greece’s position remains precarious as debt to GDP currently stands at 179%. The economy has been stagnant for years as its government continues to resist the structural reforms proposed by the IMF and Europeans. Some are optimistic as Greece recorded a primary surplus (before interest expenses) in 2016. Unlike the buyers of the recent bond issue, S&P (B-) and Moody’s (Caa2), do not see a good prospect of Greece paying back its creditors.

Iraq

In early August, Iraq sold $1 billion of five-year bonds at 6.75%, a 4.93% premium to US Treasuries. Iraq faces three major medium-term issues: the ongoing war, export revenues reliant on oil prices and dependence upon military and financial support from the US government. Each of these is out of its control. The 2016 deficit at 14% of GDP shows Iraq clearly cannot service its debts without a substantial financial turnaround. By buying the bonds, investors have effectively banked the equity case of the war ending and oil prices improving. The credit ratings from S&P (B-) and Moody’s (Caa1) are a better reflection of Iraq’s economic prospects.

Conclusion

In considering emerging market sovereign debt, investors must consider each country on its own merits. In the examples of Argentina, Greece and Iraq, bond buyers have suspended sceptical analysis. They have banked the equity case, hoping for a substantial change from historical precedents, even though they will not get a share of the upside if the rosy scenario occurs. The examples are not unusual, as shown in the graph below from Bloomberg. Belarus, Mongolia and Ukraine are all CCC-rated but have bonds yielding less than 6%.

Yields on CCC-rated emerging market bonds

sovereign debt

sovereign debt

These examples point to the greater fool theory playing out in many credit markets. We have now reached the point in the credit cycle where further gains seem dependent upon more dumb money arriving and pushing spreads even tighter. Calling the top of any cycle is nearly impossible, but calling out the current higher risk/lower return environment is simply common sense.

 

Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. This article has been prepared for educational purposes and is not a substitute for tailored financial advice. Narrow Road Capital advises on and invests in a wide range of securities.

RELATED ARTICLES

Fear of missing out trumping fear of loss

Hedge funds seizing ships – what next?

Australia’s default: who do you rescue?

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

The greatest investor you’ve never heard of

Jim Simons has achieved breathtaking returns of 62% p.a. over 33 years, a track record like no other, yet he remains little known to the public. Here’s how he’s done it, and the lessons that can be applied to our own investing.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

Latest Updates

Shares

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Property

Baby Boomer housing needs

Baby boomers will account for a third of population growth between 2024 and 2029, making this generation the biggest age-related growth sector over this period. They will shape the housing market with their unique preferences.

SMSF strategies

Meg on SMSFs: When the first member of a couple dies

The surviving spouse has a lot to think about when a member of an SMSF dies. While it pays to understand the options quickly, often they’re best served by moving a little more slowly before making final decisions.

Shares

Small caps are compelling but not for the reasons you might think...

Your author prematurely advocated investing in small caps almost 12 months ago. Since then, the investment landscape has changed, and there are even more reasons to believe small caps are likely to outperform going forward.

Taxation

The mixed fortunes of tax reform in Australia, part 2

Since Federation, reforms to our tax system have proven difficult. Yet they're too important to leave in the too-hard basket, and here's a look at the key ingredients that make a tax reform exercise work, or not.

Investment strategies

8 ways that AI will impact how we invest

AI is affecting ever expanding fields of human activity, and the way we invest is no exception. Here's how investors, advisors and investment managers can better prepare to manage the opportunities and risks that come with AI.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.