“One of the greatest disservices you can do a man is to lend him money that he can’t pay back.”
Jesse Holman Jones, US Commerce Secretary 1940-45 and head of the Reconstruction Force Corporation 1932-45, was one of the principal architects in dragging the US out of the Great Depression and certainly knew a thing or two about money-lending and the perils associated with it. His advice is critical for modern-day bond investors who are essentially money-lenders. Scanning the globe today, the largest constituency of borrowers that comes under Jones’s maxim are developed Western governments.
Governments face three choices: default on the debt, repay it or inflate the debt away. The first option is unthinkable for governments and the second looks unrealistic. In this context, the latter option is increasingly likely, which raises the question of the value in real terms of these bonds. Outside of inflation-linked debt, where then should sovereign bond investors turn?
Emerging market countries are well placed to deal with the twin concerns any bondholder has: the ability and the willingness to repay debt. Emerging market countries have an increasing share of world growth and have current account surpluses, meaning they are typically creditor nations and providers of capital to the indebted Western world. Emerging markets are also supported by structural factors. A classic population structure of more young people and relatively fewer older people, and a rapidly growing middle class. This gives emerging markets the critical factor lenders want – an expanding tax base.
This dynamic is already reflected in the credit metrics. The October IMF World Economic Outlook projects that UK debt/GDP will climb from 68.7% in 2009 to 98.3% by 2014. Indonesian debt/GDP is expected to fall from 31.5% to 27.1% and Brazilian debt/GDP from 68.5% to 58.8% over the same time period. Valuations have yet to catch up with this dynamic. UK 10-year gilts yield around 4.0% versus around 9% and 10.5% for Indonesian and Brazilian 10-year bonds. In terms of risk/reward we are very clear who we prefer to lend money to, and it is not to the indebted Western world.
Brazil illustrates the credit-worthiness and structural themes very well. At the height of the financial crisis, Brazil provided US$10bn to the IMF. In this context, it is unsurprising Brazil has been upgraded to an investment grade country by all of the major rating agencies. Preparations for the 2014 World Cup and 2016 Olympics also demonstrate the amount of investment that will be required over the next few years. This opens up another opportunity for bond investors: emerging market corporate bonds and in particular those issued by strategic infrastructure assets. Bonds issued by the Brazilian steel giant Gerdau and by regional airline TAM, yielding 6.7% and 10.2% respectively, are likely to perform well over the next few years given the pace of infrastructure spending as Brazil gears up to host the decade’s major sporting events.
2009 was an easy year for bond investors, apart from developed Western government debt, everything rallied. 2010 will be a lot more difficult. As banks continue to contract balance sheets and borrowers continue to turn to bond markets for financing, bond managers in their role as loan officers need to discriminate between borrowers. This starts at the sovereign level.
To paraphrase Jesse Holman Jones, investors are probably doing a disservice buying gilts and other developed Western government bonds at these yield levels as governments simply cannot afford to pay the debt back. Where do you want your pounds invested?
Nick Gartside is a bond manager at Schroders
