Investors are convinced that lowly rated countries and

companies are much less likely to go bust than they were. Are

they correct

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 ). Thailand’s 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 Moody’s, 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 dollar’s worth of junk that Moody’s

downgraded, $1.65-worth was upgraded. Of old, junk was more

often downgraded.

This is not a watertight case: Wall Street’s 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 ). 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 wished—and not

enough to warrant the steep fall in yields. South-East Asia

has demonstrated this amply in the past few months. Besides

Thailand’s 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 sink—especially given the exposure of its companies

and banks to the country. So it led the rescue and lent the

lion’s 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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