When default is not the end

The spilling over of Nasdaq volatility into emerging-market bonds has not amused their issuers. How can the fortunes of an internet start-up in Atlanta be intelligently compared with those of a tropical commodity producer, they ask, never mind that one is a company, the other a country?

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At first glance the link in investors' minds between the two asset classes does display arbitrariness. If investors can't distinguish between Palm Pilots and palm oil what hope is there for eYcient capital allocation? Deeper investigation, however, suggests portfolio managers are not that muddle-headed.

What tech stocks and developing country bonds have in common is many new speculative-grade issuers, valuation problems and a growing default rate. The main diVerence is that until recently investors were wildly optimistic about growth prospects for tech stocks and deeply pessimistic about emerging markets. Now they seem to be saying that both are unpredictable and they need help to Wgure them out. This will take time - for credit histories to be built and for better techniques for using the information to be devised.

That's because the markets for tech stocks and for sovereign bonds, in their present form, are fairly new. Even though sovereign issuance of foreign currency bonds Wrst became substantial in the 1820s, the present wave of issuance by speculative grade governments only began in the 1990s, when Mexico issued Brady bonds in exchange for bank debt in default. Since then other countries have taken the Brady route and many speculative as well as unrated credits have issued international bonds. Between January 1991 and November 1999, of the new sovereign ratings assigned by Standard&Poor's nearly 40% were speculative grade.

So far default rates have not been high. In the 1990s the average issuer default rates on sovereign bonds and bank debt together was 22%, but the rate was only 2.5% on foreign-currency bonds. The bad news is that this is set to get a lot higher as the switch from bank debt to bond Wnancing by poorer credits feeds through into defaults. The good news is that investors are becoming more accustomed to sovereign bond defaults and less worried about them.

Although sovereign bond defaults were once held up as an approaching Armaggedon, the reality has been diVerent. The fear was of a multitude of investors arguing over who should get paid and never coming to agreement. In fact, investors have so far acquiesced with restructurings rather meekly, perhaps mindful that they have little choice.

The crises of the past two years - Russia's default on local-currency bonds and Soviet era debt, the exchanges forced on bond investors by Pakistan and Ukraine, and Ecuador's Eurobond and Brady defaults - have all been accepted by investors as temporary setbacks. The maturing of the market has continued apace. Credits in default such as these are now expected to be able to come to the market again within one to two years. And many other sovereigns that once seemed unacceptable will make their debut over the same period (see page 118).

More issuance, more defaults, speedy workouts followed by yet more issuance is the nature of the new sovereign bond market, which is proving a lot more Xexible and agile than bank lending. With the fear removed from default, together with better credit information, the stage is set for sovereign spreads to move progressively lower. Just as the failure of Boo.com sobered up the tech market - the impact was negative but not cataclysmic - so the Ecuadorean crisis has given perspective to bond investors. Volatility may not disappear from either sector - it now seems to be a permanent feature of contemporary capital markets - but more accurate pricing can be expected.

Yet where techs will always be diVerent from sovereigns, much to the chagrin of emerging-market debt investors, is that the latter asset class gets interfered with by G7 and multilateral lenders. The campaign, by oYcial lenders to troubled governments, for private investors to share the burden with them has become increasingly controversial. Although the role of burden-sharing in pushing sovereigns over the edge has been exaggerated, it sets the scene for continued argument. It is, after all, much more diYcult for investors to judge a sovereign credit if they have to assess not only the behavioural peculiarities of the debtor government but those of oYcial creditors too.

OYcial creditors are stretching the fairness concept a bit far in asking to be viewed equally with private investors when their loans were granted on an entirely diVerent basis. Some were given for strategic political reasons, others to subsidize export industries in donor countries. Before insisting on equal treatment with private commercial creditors, they need to ask themselves whether the Xows were not in reality aid that should just be written oV?

Conversely borrowers may question whether oYcial Xows are worth all the fuss and bother. They may be forced to purchase second-rate goods and later to be caught in a burden-sharing squabble that upsets investors. Straight defaults, it seems, can be swallowed by the markets. Unburdened by public Xows the markets would function even better.

Sovereign wealth funds on euromoney.com

The world’s largest banks 2007

When default is not the end

The spilling over of Nasdaq volatility into emerging-market bonds has not amused their issuers. How can the fortunes of an internet start-up in Atlanta be intelligently compared with those of a tropical commodity producer, they ask, never mind that one is a company, the other a country?

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