FINANCE AND ECONOMICS
Why risk is no longer a four-letter word
Investors are convinced that lowly rated countries and companies are much less likely to go bust than they were. Are they correct?
CAST your mind back a little over two years, to the beginning of 1995. Mexico was on the ropes, and had been forced to devalue the peso. Fearful that the country would default on its foreign debts, investors bolted. Memories of an earlier Latin American debt crisis caused them to desert other emerging economies, too, and not just in Latin America: the shock waves were felt as far away as Asia. That March the yield on an index of emerging-market bonds compiled by J.P. Morgan stood at over 1,900 basis points (hundredths of a percentage point) above that on American Treasuries, a record. Only a $50 billion bail-out for Mexico, assembled by America and the IMF, calmed investors frazzled nerves.
They are, it is clear, frazzled no longer. This month the yield on the J.P. Morgan index was a shade more than 350 basis points over Treasuries, a record low (see chart). Thailands recent travails have caused scarcely a ripple outside South-East Asia. Yields on bonds issued by emerging countries and big companies in other parts of the world have barely budged.
And not just in emerging markets. In rich countries, yields on bonds lacking an investment-grade rating (known as junk) have fallen much faster than those on less risky paper, and are now at rock bottom. Investors seem to think that borrowers they considered horribly risky not long ago are now much safer bets; in consequence, they are demanding much less extra interest to compensate for the possibility of default. Have investors inflated a credit bubble that will, in time-honoured fashion, burst?
The fall in the price of risk has been both striking and universal. At the end of 1995, according to an index drawn up by Salomon Brothers, American junk bonds yielded about 430 basis points more than Treasury bonds. Now the gap is less than 300 basis points. In Latin America, big firms have been able to borrow in foreign currencies at rates similar to those paid by firms in developed countries.
As for government borrowers, in October 1996 Argentina had to pay 445 basis points over Treasuries when it issued ten-year dollar bonds; the spread has fallen to below 250 basis points. As recently as June, Russia issued ten-year bonds at 335 basis points over LIBOR, the rate at which the soundest banks borrow from each other in London; they now trade at 285 basis points over. Even countries that were once considered almost radioactive have seen their borrowing rates plunge. A year ago bonds issued by Bulgaria traded at almost 1,500 basis points over Treasuries; now the gap is little more than a third of that.
In the case of American junk bonds, many borrowers do indeed seem to be in better shape than they were. John Lonski, chief economist at Moodys, a credit-rating agency, points to several factors. The long-term decline in government-bond yields has meant that companies have been able to borrow new money and refinance existing debt at cheaper rates. A strong stockmarket has enabled them to rely more on equity capital than debt, and so improve their balance sheets. And soaring profits have pushed the ratio of pre-tax profits to interest charges to its highest since the late 1970s. In the first half of this year, for every dollars worth of junk that Moodys downgraded, $1.65-worth was upgraded. Of old, junk was more often downgraded.
This is not a watertight case: Wall Streets 1980s junk-bond boom ended in tears. But most fears about investors misjudging risks centre on emerging-market debt. True, many emerging economies look in better nick than they did. The ratio of their external debt to GDP has fallen, estimates the IMF, from 38.3% in 1992 to an expected 30% this year. Inflation has, in general, been cut, making currencies more stable and foreign-debt defaults less likely. In 1994, says the Fund, developing-country inflation was 51%; this year, it should be below 10%. Some countries have seen spectacular falls: Latin American inflation, 200%-plus in 1994, is expected to be 12% or so in 1997; in Russia, where prices rose by 1,350% in 1992 and 300% in 1994, the IMF expects inflation of only 14.2% this year.
Taking advantage of their improved economic conditions, developing countries have been rushing to issue bonds in the international markets (see chart). They have found no shortage of takers. The money comes mainly from two sources.
The first is portfolio investors. Low interest rates at home (ten-year government bonds yield about 6.4% in America and a measly 2% in Japan) have pushed investors to seek higher yields. Micropal, a British research firm, now tracks 208 emerging-market debt funds which in total manage $17 billion-worth of assets. On average, these funds are only two years old. Hedge funds have also been piling in.
Banks, too, have been falling over themselves to lend to riskier credits at home and abroad. Bumper profits have left lots of them, especially in Europe and America, with excess capital. Many now have capital worth well over the minimum 8% of risk-weighted assets demanded by international standards. At the end of 1996, according to the Banker, 15 of the top 25 banks had ratios over 10%. Some have been returning this to shareholders. But by no means all of them.
International syndicated lending grew from $310 billion in 1995 to $530 billion last year. Much of the increase came from lending to riskier borrowers in both domestic markets and emerging ones, often at slender rates. According to Capital Data, a London research firm, spreads on banks lending to junk borrowers have shrunk from just over 200 basis points at the beginning of 1995 to 150 basis points now.
But the economic fundamentals have not always improved as much as either bond investors or bankers might have wishedand not enough to warrant the steep fall in yields. South-East Asia has demonstrated this amply in the past few months. Besides Thailands difficulties, Malaysia has a large current-account deficit and Indonesia has borrowed lots abroad. South Korea has both these problems.
Yet investors have shown no signs of fundamentally reassessing the creditworthiness of countries in Asia as they did in Latin America two years ago. There has been no panic selling. In June a ten-year dollar bond issued by the Thai government yielded 85 basis points over Treasuries; now it trades at about 135 basis points over, even though the baht has fallen by a quarter against the dollar. A Philippine 20-year bond trades at a lower spread than at its launch in September 1996, even though the peso is at record lows against the dollar.
One reason for investors sanguine reactions seems to be the feeling that countries are simply not allowed to default any more: the IMF, together with rich countries, will always come to the rescue. On top of the $50 billion Mexican package and a small one for Bulgaria last year, Thailand is set to receive a $16.6 billion bail-out.
Who dares lends
Yet there are reasons for caution. Both Mexico and Thailand were special cases. America, having nurtured closer economic and political ties with Mexico, was never going to let its neighbour sinkespecially given the exposure of its companies and banks to the country. So it led the rescue and lent the lions share. In Thailand, Japan had a keen interest in helping out. Its banks are the biggest lenders; its companies provide one in seven Thai manufacturing jobs. But other countries (and investors) might not always be so lucky.
Moreover, although big banks in emerging countries will probably not be allowed to fail, given their key roles in countries with underdeveloped capital markets (this week, South Korea guaranteed its banks external debts), the same is not necessarily true of big firms: Hanbo, a big Korean steel maker, recently went bust. And often it is a condition of IMF aid that countries do not prop up ailing companies: Thailand has had to let many financial firms fold.
All of which suggests that lenders, both bond buyers and banks, have been more concerned with the quest for returns than with a cool-headed analysis of credit risk. Until the recent turmoil in South-East Asia, there has not been a single instance where spreads on emerging-market debt over Treasuries have widened over the past year, whatever their economies have done. And while risky debt may look alluring now, the worst loans have often been made in what seemed the best of times.
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