The investment market at times resembles a circus in which the strangest acts sell the most tickets. In the latest bit of acrobatics, sovereign junk bonds issued by national governments are turning in their best performance in years. For example, European sovereign junk returned 100 per cent in the nine years since the mid-2008 beginning of the global financial crisis. Why has junk gotten so much respect? The answer has two distinct parts, each very sensible and each a lesson in the new world of what it takes to make money off the farm.
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First, there are returns. In order to rescue the world financial system from towering debt, much of it derivatives (financial instruments that take their price from other financial instruments) in such things as U.S. mortgages that turned out to be valueless, the world’s biggest central banks bought bonds. That made bond prices rise and the yield on bonds, which is the coupon interest rate divided by the bond’s price, tumble. Bonds issued by the European Central Bank and the Bank of Japan actually turned in negative yields. So did German bonds. U.S. Treasury bonds due in 90 days or less produced negative yields for a couple of long weekends in 2008 and at Easter, 2009 when the fear of global collapse was so great that large banks and investment funds paid more than the redemption price to buy the bonds. Buyers paid to store money for fear that the banks they might put it in would not be around at opening time Tuesday morning. Bargain basement interest rates allowed banks to borrow through term deposits at some of the lowest rates in history.
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The world’s biggest central banks rescued fallen commercial banks such as New York’s giant Citigroup by allowing them to borrow money at rates as low as a fraction of one per cent. Investors, turned off by ridiculously low interest rates, bought junk bonds that had payouts in the customary mid-single digit range or even more. That is still going on, for the vast majority of the world’s 200 or so nations cannot issue investment grade debt.
In August this year, Greece, which had a good deal of its public debt written off in 2012, was able to sell US$3.5 billion of fresh bonds. Argentina recently sold a U.S.dollar-denominated bond due in 100 years. Argentina defaulted six times in the 20th century. It has just settled its latest defaults going back to the 1980s after decades in U.S. courts. Presumably, investors think, the country has turned the page and is now trustworthy.
The idea that old defaulters won’t do it again has gained traction. Ivory Coast, for example, issued a bond in 2010 to pay for older bonds the interest on which it could not pay (a “refinancing” in polite language) and then defaulted on the 2010 issue in 2011. More recently, the Democratic Republic of the Congo, which has a lot of minerals as well as one of the world’s last officially communist regimes, sold bonds. The prospects for payment of interest and principal vary from questionable to dim, but these bonds are a hit. Why? There are two explanations.
This is reason two. Bond index funds have to buy the stuff. As recently as two decades ago, bond investors would burrow into voluminous research reports on the credit worthiness of any new bond to hit the market. For- eign bonds had to be AAA at the top or maybe no worse than a middling B to get sold. Bonds rated C, which is the letter grade of junk, did not get sold.
Global bond funds
Today, global bond funds structured to replicate their markets follow every twist and turn of their underlying assets such as global emerging market debt, long or short U.S. domestic junk, or Asian speculative grade indus- trial bonds. Congo government junk has ready buyers and default no longer matters. All that counts is the global bond exchange traded fund’s mandate and the fact that the fund has gushers of cash coming in. The money has to be invested, for ETFs almost never hold cash.
Oddly enough, the odds favour the global junk bond ETFs. Research shows that bottom-of- the-barrel stock and bond markets go through a renaissance and that those at the bottom fix themselves and then return to respectability. Buying the worst performing national markets one year and then waiting a year, then selling, turns out to be much more profitable than buying winners.
The turnarounds work when the laggard, even bankrupt governments, loaded up with unpayable debt, drained by paying huge subsidies to allow their citizens to buy food or gasoline, then devastated by high inflation, go cap in hand to the International Monetary Fund. It’s a bank of last resort for failing nations. The IMF loans them money, imposes strict conditions, forces cuts in subsidies, knocks down inflation, and the formerly bankrupt countries return to respectability. Lately Argentina, which created a tax amnesty to allow its wealthy citizens to bring back U.S. dollars without penalty, and Egypt, which is trying to bring down food price inflation running at 40 per cent per year, have seen their sovereign bonds rise in price, yields come down, and fresh bonds they have issued eagerly bought by investors. Note that in the bond market communist governments, dictators and even national despair as in Greece where people have lost government pensions are just details. Bondholders usually rule.
Bond exchange traded funds have replaced the eyeshade-wearing credit analysts who used to be kept out of sight in backrooms. Today, emerging market nations can be sure of a sale. Their offering rates of seven per cent or even more in what is now called the “frontier market” compensate for some risk.
What will happen if markets turn and investors want out? If investors in these global junk bond funds want to sell their ETF units, the funds will have no choice but to sell their bonds holdings. In a global selloff there will be no one to buy those dicey bonds. Their prices will plum- met. There will be no one to mop up the blood on the floor, for actually getting paid by the underlying bonds is going to be a dim prospect — as it always was.
It has not happened yet. As long as U.S. Treasury 10-year bonds pay around 2.2 per cent, about half the historic five per cent rate, global sovereign junk paying seven per cent or more is going to have a solid market. If interest rates in the U.S., Canada and Europe, Japan and the U.K. start to rise smartly, money may start leaving global junk. That could be the trigger.
Bonds are supposed to be life preservers when stocks fail. In my view, junk bonds issued by governments on shaky foundations and held not by choice, but just by mandate requiring funds to hold them, are a financial juggling act that is doomed to fail. These bonds are the dot coms of the bond market. Those who feast on this banquet of bad bonds will eventually lament that they bet that the improbable would succeed.
