Banking On Bonds

One of the biggest changes in world markets over the last decade has been the prevalence given to fixed income by private investors.

Once institutional investors realised that there was more to the world than Europe, Japan and the US, money began to make its way from London and New York into emerging markets in pursuit of higher returns.

What were missing were bonds, particularly bonds issued in local currency. True, some markets had relatively large local bond markets, but on average in the emerging world, debt (particularly corporate debt) came a very distant second to equities in terms of market size and attractiveness for local investors.

A number of countries, India and South Korea for example, had relatively large bond markets but access was barred to foreign investors. Without openness and competition, markets don’t tend to grow.

That all changed in three stages. First, the financial crises in emerging markets in the second half of the 1990s brought home the lesson that having a USD pegged exchange rate, and therefore US interest rates, didn’t allow for the proper calculation of a risk-free interest rate. Without that it was impossible to properly value equities.

The lessons of the Asian Financial Crisis, in particular, were that even countries running large government surpluses would benefit from the creation of a local currency bond market, as the true risk free rate was twice if not three times the USD 30-year bond yield. Many governments began to issue debt in their own currency and create yield curves in their own currency to reflect local, and not US, risks.

The second was institutional. Corporate governance and market transparency improved after the crisis of the 1990s. It’s much easier to convince private investors to lend if there are legal statues and regulations in place to guarantee their place in the queue for repayment in the event of a default. Thus, not only did we see creation of local currency bond markets, but the circumstances leading to their creation also allowed corporates to issue debt and lenders to believe they had legally enforceable claims based on legitimate valuations.

The third change came with the rise ofdeflationary pressures in the developed world after the bust following the dot. com crash. The great moderation, as it was mistakenly called, was the forerunner of a deflationary bust in developed markets as capital became conspicuously mispriced by G7 central bank manipulation of interest rates. This was compounded by the preposterous creations of financial engineering that eventually brought the sub-prime crash and mutualisation of private debt by governments across the developed world.

We now find ourselves in a world where there is a plentiful supply of very low yielding G7 debt and much higher yielding debt in emerging markets. On average, credit ratings are moving in the opposite direction to the stagnating G7. Private investors now have the opportunity to place funds in investment grade credit with yields similar to equity dividends and assign them as collateral.

Currently the preference amongst private banking clients is for hard currency debt and bonds of short maturity as their performance
is less sensitive to sentiment.

Sooner or later, equities will recover their ground and become the asset class of choice again. All asset classes eventually become over-valued after a long period of investor preference. But the position of equities as the major means of investing in countries and corporates outside the developed world is no longer predominant.

As rates in the G7 slip lower, equities will no longer be the dominant means of raising capital either. This is a reflection of how much more stable and sophisticated emerging markets have become in the last 15 years.

And this is the reason why we recommend that all of our clients seek out investment opportunities in emerging markets, rather than remaining focused on the US and Europe.