Bonds from emerging countries like Brazil, Russia, Mexico and elsewhere are a major investment theme, a Zeitgeist. They offer quite an attractive yield, often 5, 6 percent or more, which seems reasonable, relative to their risk, at a time when interest rates on bank accounts are zero or very low.

What type of risk is there, alongside that kind of interest? There would not be direct currency risk, since this Zeitgeist is focussed on bonds denominated in (or hedged into) euros, not in the local currency of the issuing country. But there is credit risk. Argentina, for example, defaulted on its bonds less than ten years ago, paying back only a fraction of their value, and has only just settled a complex lawsuit, while Venezuela looks set to default soon. And even if a country does not default, the price of its bonds can fall quite a long way when investors get scared. That happened with Russia, for example, a couple of years ago, even though the prices later recovered most of their losses.

Brazil, and now Russia seems set to gradually move to modest positive growth

One way to understand this credit risk, is to look at political risk and economic risk. Three of the biggest issuers, Brazil, Russia and Mexico, provide an illustration of this.

In Brazil, Dilma Rousseff, who had been re-elected as President in October 2014, was suspended from office in May 2016 when the Brazilian Parliament voted to commence impeachment proceedings, and Michel Temer took over as acting President. In parallel, many politicians and others connected to the country’s main petrochemical company, Petrobras, face accusations of corruption, and the economy is in recession, hurt by the fall in commodity prices over the last few years and the failure to reform earlier, when the money was flowing.

The price of Brazilian bonds fell sharply during 2015 as the recession deepened and the impeachment process gathered pace. But as it became apparent that the process would likely lead to a change of power, the markets began to recover some but not all of their losses. At time of writing (mid 2016), it seems that the prices reflect the balance of risks between the evident problems in the economy, and the more positive possibility that the new President will successfully implement reforms to address some of the worst issues. If the reforms help Brazil to diversify, the economy has great potential to starting growing again at a good pace. So a lot of bad news is in the price and it can be argued that these bonds are somewhere around fair value, not cheap but offering reasonable value for the risk.

The economic problems faced by Russia, another big issuer of bonds, bear some similarity with Brazil in that both have economies dependent on primary commodities, and neither used the commodity boom years from 2008-2013 to make major diversifications into other sectors. But the political difficulties are different, centring on the substantial geopolitical tensions with the West. Sanctions are in place, and these helped trigger a recession last year, along with the collapse in oil prices. But the recession was nowhere near as deep as in Brazil, and now Russia seems set to gradually move to modest positive growth later in 2016, especially since oil prices look to have stabilised. Looking further ahead, to return to the faster growth rates seen a decade ago, the economy would need to diversify. Projects such as the expansion of ports to serve new routes opened up by global warming, and construction of major tourist attractions, fit quite well with the current relatively centralised way the economy is currently run.

Mexicos economy is significantly more diversified than either Brazil or Russia

What’s also important for bond investors is that Russia enjoys the financial stability that comes from a current account surplus. And government spending has been cut in response to lower oil prices, and private spending has also fallen in real terms. So although Russian bond prices have recovered a long way since the sanctions were first imposed in 2014, overall it seems that Russia also offers reasonable value emerging market bonds, even if the sanctions remain in their current form for some time. And there is a possibility that there might be some form of limited reduction in geopolitical tensions that allow some reduction in the sanctions before too long.

Turning to Mexico, which is also a very large issuer of bonds, there is some dependency on oil, but overall the economy is significantly more diversified than either Brazil or Russia. There is substantial trade with the US in manufactures, and as the US has grown in recent years this has ensured that Mexico did not suffer a recession when oil prices fell. However, this pattern of trade creates a different kind of political risk, related to the US elections late in 2016. Donald Trump has said he wants to end the trade deal with Mexico, as well as building a wall, and even Hilary Clinton is cool on trade deals now. However, changing an international Treaty will involve a long negotiation, and if the Republication party retains power in one or both houses of the US Congress, it is likely to resist major attacks on existing trade deals. Moreover, Mexico has quite a few cards in its own hand, as a major buyer of US goods.

There is another important type of risk that is common to all these three markets and to the other, smaller issuers of emerging market bonds. This is the potential impact as the Fed gradually continues with its programme of raising interest rates, which it started in December 2015. Back in August 2013, the price of emerging market bonds fell sharply when the Fed talked about ending its Quantitative easing programme. Investors were worried that could slow economic growth and make it more difficult for emerging countries to pay back debt, and they worried that US bond yields would go up, dragging investors away from emerging bonds. In the event, those fears turned out to be greatly exaggerated and within about six months, the prices had recovered. Moreover, since 2013 many emerging countries have improved their financial position by reducing their current account deficit, which they have done by cutting spending by more than needed to offset the loss of oil and commodity revenues where those are important to their economies. This has made them less vulnerable to rising US interest rates.

Bronwyn Curtis Obe

“Emerging Countries like Brazil, Russia and Turkey offer more.”

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