Sovereign Bonds: A wealth of opportunity
Martin Steward spoke to Stratton Street Capital, which believes that a sovereign’s wealth determines the performance of its bond and currency markets
Homespun wisdom suggests two types of people you should not lend to: friends and family; and anyone who needs the money.
Institutional investors tend not to have to worry about the first, but they have plenty of exposure to the second. Witness the common criticism of standard bond indices: market capitalisation weighting means a bias to the most indebted bond issuers.
Stratton Street Capital is a bonds specialist that takes the relative wealth of the countries it lends to more seriously than most. But it does not focus on the debt-to-GDP ratio. Instead, it looks at net foreign assets (NFA) – the value of the assets a country owns abroad minus the value of the domestic assets owned by foreigners.
“For a great example to show why NFA data is useful, consider Iceland,” suggests Andy Seaman, partner and co-founder of Stratton Street.
When Moody’s upgraded Iceland to the coveted Aaa status, its overseas liabilities had reached 86% of GDP, up from just 48% in 1997. The ratings agency looked at government debt ratios, which remained fairly modest, missing the enormous foreign liabilities the country’s citizens, corporations and banks had amassed. But where would the sovereign be if and when those private debts went bad?
“By May 2008, overseas liabilities-to-GDP reached an extraordinary 180%, and Iceland was still somehow a Aaa credit,” notes Seaman.
Iceland was not the only example, he reminds us – see figure 1 for more. Today, Lithuania, Poland, Romania, Australia and Spain all have net foreign liabilities close to or above 100% of GDP, and are rated BBB, A-, BB+, AAA and BBB-, respectively, by Standard & Poor’s. Even during 2009, with the crisis still raw, worry focused on Eastern Europe while markets pushed Greek two-year bond yields to their all-time low of 1.27% on 24 September.
“That was six days after the launch of our fund,” Seaman recalls.
The Wealthy Nations Bond fund was launched in September 2009 to complement the firm’s existing Wonda Bond and Currency hedge fund and Renminbi Bond fund, with the specific aim of minimising exposure to countries with low NFA-to-GDP ratios. It now accounts for just over $1bn of Stratton Street’s $1.8bn under management.
The strategy is built on the hypothesis that, when markets have an appetite for risk, the assets of poorer countries benefit relative to those of wealthy countries; and that this reverses in a de-leveraging cycle when markets seek to avoid risk.
The empirical evidence that NFA-to-GDP ratios correlate with this dynamic was strong in the year after the Wealthy Nations fund launched. Currency returns for the ‘risk-off’ world of 2010 show the Japanese yen top of the table. Japan is wealthy in terms of NFA – its massive government liabilities are mostly owed to its domestic population. The Australian dollar came second, bucking the theory, as Australia has large foreign liabilities. But then there are the currencies of Malaysia, South Africa, Switzerland, Thailand, Taiwan and Singapore – all wealthy on the NFA-to-GDP measure. The bottom of the table was even more persuasive: Hungary, Romania, Latvia, Lithuania, the euro, Estonia and Bulgaria.
Take the seven countries in figure 1 and add the five that we identified as highly indebted but highly rated today, and only Iceland, Australia and Poland are missing.
Unlike the Wonda fund, Wealthy Nations has no currency exposure, but these relationships also hold with bond valuations. This was something Seaman noticed as far back as 1995, when he happened to come across a list of countries ranked by NFA. With Japan at the top and New Zealand at the bottom, he was astonished to see that the list was almost identical to the list ranking bond market returns from the previous year, 1994. For 1993, the list was completely switched around, but every country still ranked roughly in line with its NFA.
“Correlation was 0.85,” Seaman recalls. “I couldn’t figure out why there should be this link and couldn’t find anything in the academic literature, either.”
He asks us to imagine that the world has just two countries, Japan and New Zealand, with the same fundamentals and the same interest rate. Then assume New Zealand needs to borrow from Japan. The interest rate on New Zealand’s debt will have to rise at the margin to attract that capital, and if there is appetite to take risk the capital will flow and push the rate down again. If the appetite for risk evaporates, investors forego the extra yield for safety, the capital flows back home and rates go up.
“New Zealand’s debt outperforms in a bull market, Japan’s in a bear market,” says Seaman. “It worked in 1993 and 1994; it happened in 1998 when there were big current account deficits in many of the Asian countries that saw capital flood out; again in 2002; and it’s how we made a 68% return in the Wonda portfolio in 2008, being short debtors like Australia and long creditors like US and Japan.”
The theory doesn’t help if you can’t tell which are the wealthy nations, and NFA has historically been sparsely and inconsistently published. Again, some fortuitous timing helped: 2007 saw the publication of work for the IMF by Philip Lane and Gian Maria Milesi-Ferretti that aimed to assess the NFAs of 178 countries – resulting in a database updated by Stratton Street for the 128 that are rated investment-grade.
Figure 2 shows a selection, ranked by their NFA-to-GDP ratios – and it throws up a few surprises. We have already mentioned the misapprehension around Japan. At 62% NFA-to-GDP, it is in better shape than China, Germany or the Netherlands. And Australia, at 81%, looks like an accident waiting to happen.
“You’d think that a commodities boom would have made a major commodity exporter fabulously wealthy but, in fact, Australia has the distinction of having run a current account deficit every year for the past 30,” says Seaman. “In an inflationary world where capital is always looking for a home, financing a current account deficit is not so difficult. But when the world enters a de-leveraging cycle and competition for capital heats up? We are beginning to see what that means for the Aussie dollar.
The other big shibboleth questioned by this data is the now well-rehearsed idea that emerging economies are all net creditors and developed economies are all highly indebted. Of course, it’s no shock to see Switzerland, Norway and Germany in the 50%-plus club. But would you have guessed that France was in the black? That Ireland and Italy rank higher than India, Indonesia and Turkey? Or that the fiscally-paralysed US ranks higher than Mexico and Brazil?
“It’s a mental trap some have fallen into,” says Seaman. “But it’s simply not true to say that the emerging countries, as a block, are the wealthy nations of the future. Specifically, there is a big difference between emerging Asia and emerging Europe. With that in mind, look at the ELMI+ index: it has 36% in Eastern Europe – more than all of Asia combined. China is less than 2% of the index, while Hungary represents 5%.”
And so we return to the anomalies of cap-weighted bond indices and the wisdom of not lending to those who need the money. But, as we have seen, simply flipping those bond indices upside down doesn’t solve the problem: beyond the simple debt-to-GDP measure, countries like Japan, France, Italy and the US remind us that sovereigns can have both contingent liabilities and untapped sources of revenue linked to what their citizens and corporations have been up to. Investors would do well to recognise this.