Emerging Markets Dollar Bonds Present Intriguing Investment Option

 | Jun 22, 2017 | 8:00 AM EDT
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With investors searching for yield in an environment of increasingly expensive assets, finding one asset class that still looks underpriced feels a bit like striking gold (I was going to say find oil, but thought better of it).

One such find could be a rather neglected asset class: emerging markets dollar-denominated debt. U.K.-based economic think tank Oxford Economics has advanced an intriguing idea: Emerging markets dollar-denominated bonds currently are underpriced because investors exaggerate their risks.

For a long time, the conventional thinking has been that there is quite a high default risk for the debt of developing countries denominated in dollars or other foreign currencies. However, this view overlooks the fact that over the past decade or so, the share of domestic debt in emerging markets has advanced rapidly while dollar-denominated debt has shrunk.

Credit agencies are slow to recognize this reality in the opinion of Gabriel Sterne, head of global macro research at Oxford Economics.

"Emerging markets sovereign ratings may be too pessimistic, as they rely partly on historical default probabilities. This means it could take decades for ratings to catch up with an improved reality," Sterne wrote in recent research on the issue.

A small share of dollar-denominated debt in a country's total debt means the incentive to default on the dollar debt also is small because there are serious reputational risks for countries that default. Instead, the country could try to "punish" domestic bondholders by stoking up inflation to erode the debt denominated in its own currency.

Local currency issues as a percentage of total external debt in 14 large emerging markets increased to 60% in 2012 from just 15% in 2004, according to Oxford Economics.

The research carried out by the think tank shows that default rates on sovereign bonds with ratings from BBB to B could fall by around 40% to 8% if the issue of the small share of dollar-denominated debt is taken into account.

There also has been a shift in the way developing countries default on their debt, and this shift helps to reduce investors' losses. Reprofiling the debt -- the mildest form of restructuring, which involves extending maturities rather than imposing big haircuts on bondholders -- is becoming a more popular way to deal with problem debt.

"With reprofiling-type defaults increasingly common and substantial haircuts less so, the average losses associated with default could be much lower, at 25%, rather than 50%," Sterne wrote.

Therefore, countries with a low percentage of dollar-denominated debt are the least likely to default on it. In China, Brazil, India, Malaysia, Nigeria and Vietnam, foreign exchange-denominated debt makes up less than 5% of total external debt.

The next less vulnerable groups are made of Azerbaijan, Georgia, Angola, South Africa and Morocco, with between 5% and 10% of debt denominated in dollars, and Russia, Chile, Guatemala and Latvia, where dollar-denominated debt makes up between 10% and 20% of total debt.

At the other end of the spectrum, in countries such as Argentina, Belize, Croatia, El Salvador, Jamaica, Lebanon, Panama, Ukraine and Uruguay, foreign exchange debt represents more than 20% of total debt.

The idea that some of the dollar-denominated debt in emerging markets could be had for a bargain price is tempting. However, Oxford Economics warns there are risks to its theory, and they are not negligible.

Foreign exchange bondholders could be asked to take bigger haircuts because it is politically easier to treat domestic bondholders more favorably. Also, the country could find that depreciating away its currency to inflate domestic debt is too painful, as high inflation hurts the poor the most and even could spark a financial crisis like the one seen in Asia at the end of the 1990s.

Last but not least, defaults in emerging markets could be triggered by financing and liquidity problems even if the total ratio of debt to GDP is low, because these markets aren't as diversified and sophisticated as mature markets.

With returns even on high-yield bonds likely to cool down in the second half of the year, fixed-income investors could look to emerging markets for better returns. As long as they are aware of risks, their search looks set to prove fruitful.

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