On 23 December 2001, the Argentinean government stopped servicing its debt. It was not the first time Argentina has defaulted – there have been four other occasions since the 1820s. It certainly was not the first default among emerging market sovereigns – Mexico, Pakistan, Ukraine, Ecuador, Russia and Indonesia have all gone that way in recent years.
Argentina’s was the biggest sovereign default in history, involving over $80bn (e67bn) of debt. And it was undoubtedly one of the most painful – an economic, political and social catastrophe. Yet despite the epic scale of the default, Argentina has emerged from the crisis. The economy has rebounded with unexpected vigour. The debt exchange came to a surprisingly successful conclusion. And Argentinean bonds have recovered rapidly.
This is a classic example of why ‘default’ does not have to mean ‘defunct’ where investing in emerging markets is concerned. Clearly, you do not want to be caught with an emerging market credit in your portfolio when a country goes into default. But for sophisticated investors, the aftermath of a default can produce some of the most attractive investment opportunities.
Emerging market debt is not the narrow, volatile asset class it once was. Recent years have seen widespread structural improvements in many emerging countries. Government finances have improved across the board with current accounts generally more balanced – which means less foreign borrowing and better liability management. Emerging markets have benefited from rising commodity prices which have helped to improve economic fundamentals as well as the balance sheets of companies.
As a result, credit quality has improved dramatically. In 1998, less than 10% of the asset class was investment grade. Today nearly 50% of the asset class is investment grade. Many countries have been able to re-profile their debt and their ability to withstand negative credit events in other emerging countries has therefore greatly improved. The broadening of the investor base is another positive long-term trend that is helping to reduce overall volatility and improve liquidity. Given this generally improved environment, the likelihood of unexpected defaults in emerging markets has been greatly reduced, but it certainly cannot be ruled out altogether.
Unlike companies - which can cease to exist in the event of bankruptcy - even those countries that find themselves in the most extreme situations do not disappear off the face of the earth. And they do not disappear off the investment radar either. Indeed, because they are sovereigns and because, in most cases, they still have the potential to generate dollar revenues, the period during and after the default can provide opportunities to produce some of the most healthy returns.
As a government restructures its debt it will endeavour to do so in a less onerous fashion for the country, with this typically resulting in them paying less in terms of coupon payments. This will usually be over-reflected in the market price because of the volume of forced sellers as the bonds go into default, which can be a very attractive opportunity for investors. At a very basic level, the fact that less people can buy a defaulted asset than a performing one is an opportunity in itself.
History has shown that emerging market crises tend to be short-lived and are typically followed by strong recoveries. Bond prices typically suffer significant falls following default but begin to rally from the restructuring announcement until the completion of the restructuring exercise.
Take the Russian crisis of 1998, for example. That was probably the most significant year in the history of the asset class. The impact of the default was catastrophic, with Russian bonds losing over 80% of their value to trade at around 15 cents to the dollar in the aftermath. Yet, almost immediately after the default, Russia embarked on a new cycle of economic growth, with the economy growing 5.3% in 1999, 9% in 2000, and subsequently growing in excess of 5% annually. The strength of Russia’s recovery is essentially due to its status as a major oil producer and rising oil prices. Thanks to oil revenues, Russia’s debt problem resolved itself.
Consensus views on Russian bonds in the aftermath of the crisis and in subsequent years were dominated by memories of the default. Yet Russia produced an annual return of 162% in 1999 and 55% in 2000, and has been one of the best performing countries in the asset class every year since.
Argentina’s recovery after the default in late 2001 has been similarly impressive. Argentina experienced complete chaos in the aftermath of the default with the peso plunging to less than one-third of its one dollar parity – pushing the public debt ratio to more than 135% of GDP at the end of 2002 (from 63% year end 2001). The country’s banking system was severely weakened and economic activity contracted sharply across the board. The recession intensified in 2002, with GDP contracting by around 11% and unemployment rising above 20%. Rather surprisingly, for the next two years the economy actually grew very strongly despite the country continuing to be in default – GDP grew by more than 8% in 2003 and 9% in 2004. Given the extent of Argentina’s decline there was bound to be a bounce-back of some sort. But the economy was also growing because Argentinean exports had become very competitive given just how much the currency had sold off.
While post World War II sovereign defaults have typically lasted less than one year, Argentina was painfully slow to restructure its debts, presenting the terms of the debt exchange in January 2005 after some three years in default. This was largely due to the size and complexity involved: Argentina defaulted on more than 152 varieties of paper (compared with just three in the case of Russia), denominated in six currencies and governed by eight different jurisdictions. And with the economy ticking along nicely, there was little incentive from the Argentinean side to resolve the default.
Even after 76% of bondholders accepted the offer it was not all plain sailing. Argentina was scheduled to swap $62.3bn in defaulted debt on 1 April but the exchange was delayed by a bondholder’s appeal of a court decision blocking attempts to seize $7bn in bonds. The delays weighed on asset prices in March and April, although given Argentina’s strong capacity to pay, markets probably overreacted somewhat to the risk posed by litigation. The final ruling in Argentina’s favour did not come until mid May, finally clearing the way for the debt exchange.
From a bond market perspective, the post-exchange story has been a very positive one. Argentinean bonds were the best performing bonds in the emerging market universe in June and July. The euro and dollar denominated bonds have traded up around 8% since the closure of the deal. This performance has essentially been driven by two factors. Firstly, the attractiveness of the yield emerging from the restructuring – with yields of over 10%, the new bonds are the highest yielding bonds in Latin America (aside from Ecuador), and given the current yield-hungry environment, these are assets investors want to own. So technically, despite the unprecedented size of the restructuring there are probably more net buyers as a result of it than there are net sellers and this has helped to boost the resale value of the new bonds.
Secondly, the economic backdrop has remained very favourable. Strong growth has been supported by a robust recovery in investment which has already surpassed 1990s levels and the successful debt restructuring has added dynamism to the recovery. The peso-denominated bonds have fared even better, gaining over 15% over the period. The main driver here has been the positive outlook on the Argentine peso against the dollar.
Looking ahead, the outlook for Argentinean debt remains very positive. The substantial debt relief provided to Argentina by the restructuring has significantly improved its debt sustainability outlook. Standard and Poor’s has already upgraded Argentina’s rating to B– from SD (selective default) following the financial close of debt re-scheduling. Argentina’s prospective payment ability going forward is likely to be high so we would expect to see further upgrades.
What is more, these are still the highest yielding bonds in Latin America at a sovereign level. And the economy is still growing strongly at around 8%. While we do expect to see some issuance in Argentina during the second half, it is likely to remain muted. In general we think yields are still too high, with too much risk from the restructuring still priced into bonds at current levels.
The improving trend in emerging markets is clearly very positive for the asset class. As confidence in the asset class has grown, the investor base has broadened, with far greater interest from pension funds, insurance companies and other institutional investors. Yet some of the most interesting investment opportunities exist outside the general improving trend. Astute investors will see potential even when things look their worst.
So, countries do default which is undoubtedly a catastrophic event. But countries also recover – and the recovery can be equally extreme.
David Dowsett is senior portfolio manager, emerging markets at BlueBay Asset Management in London.