The hunt for yield in an era of diminishing interest rates has lured investors into ever riskier regions of the bond market, prompting some to ask: who is buying this stuff and are they suffering short-term memory loss?
In June, euro zone member Cyprus returned to the market just a year after international lenders bailed it out and the government forced bank depositors to forfeit uninsured savings.
Ecuador, which defaulted in 2008 and in 2000, raised $2 billion with a bond, and Kenya, troubled by attacks by Somalia-linked Islamist militants, had investors offer it more than four times the $2 billion it borrowed via a debut Eurobond.
In April, twice bailed-out Greece, whose 2012 debt “restructuring” was classed as a default by credit rating agencies, borrowed 3 billion euros in five-year bonds. Investors expressed interest in buying 20 billion euros worth.
All four issuers have speculative-grade credit ratings – a warning flag that they could have trouble paying as promised.
Typically such borrowers offer relatively high interest rates to compensate for the inherent credit risk. But in a world of near zero interest rates and sub-3 percent yields on U.S. Treasury bonds or German Bunds, the rates being demanded for taking on significant additional payment risk have shrunk.
Kenya’s 10-year bond yielded 6.875 percent at launch and Ecuador’s 7.95 percent. The Cyprus bond offered 4.85 percent.
The German or U.S. governments used to pay such rates for 10-year domestic currency debt prior to 2000.
So who’s suddenly willing to throw caution to the wind?
The Bank for International Settlements, the global forum for central banks, warned this week that a pre-crisis credit environment was re-emerging and that pension funds and other long-term investors are taking ever bigger risks.
“The one thing that is different between now and 2006/07 is that the protagonists… are no longer… the banks. Long-term investors are also joining in,” chief economist Hyung Song Shin said.
But how do they get sucked into lending to serial defaulters and near bankrupt nations?
Some simply make a credit assessment and reckon this time will be different. Others assume they will not hold the securities long enough to find out.
But if a high percentage of initial bidders sells out after a few weeks or months and when arrangers’ commitment to support the market for the bonds expires, someone must be picking up the bonds, even if at a lower price, and becoming a creditor.
Often the short-term speculative players have ready-made buyers in index-tracking high-yield or emerging market bond funds whose coffers have been swollen in recent years by relatively conservative investors such as pension funds desperate for higher returns and widely diversified holdings.
In some cases the former simply “flip” the debt on to the latter group, who buy it once the banks arranging the sale indicate they have sufficient bidders to qualify the bond for global investment indices.
Market timing is then the name of the game rather than the assessment of long-term credit risk.
“When you play chicken, who’s going to go first?”, said Guido Barthels, chief investment officer at Luxembourg-based fund manager Ethenea, which bought the Cypriot and Greek bonds.
“There’s hardly anyone out there who’s willing to hold this until it matures, perhaps only the local banks,” he said of the Cyprus bond, which has since fallen in price to yield 4.97 percent.
“It’s a question of who gets out first.”
While funds that buy and sell quickly in search of returns may inflate the size of the deal – itself a criterion for drawing in more passive funds – they do increasingly find themselves in the queue with more traditional buy-and-hold investors.
“People are getting forced into taking more risk in order to make what were previously easy attainable returns,” said Peter Doherty, Chief Investment Officer of Tideway Investment Partners.
“It’s amazing how short people’s memories are.”
In the case of Cyprus, hedge funds bought 27 percent of the issue, other fund managers took 51 percent and banks 22 percent. The picture was similar for the Greek bond.
While many pension or insurance funds would not be permitted to buy debt below a stated credit rating, they will have proportions of their portfolios – often labeled as a diverisfying ‘alternative’ investment – that are able to buy into, for example, dedicated emerging market funds that measure themselves against catchall indices or all-inclusive benchmarks.
JPMorgan, which runs one of the main emerging bond indexes, said emerging market dollar-denominated fixed income funds had seen inflows of $10.9 billion of new money this year and so have funds they need to deploy in buying new bonds.
The existence of the indices is a big incentive to buy and accounts for many of the long-term holders of such bonds.
“Plenty of investors do that. They hope it gets the additional index inclusion boost,” said David Spegel, global head of emerging markets sovereign and credit research at BNP Paribas, adding that the bank syndicate desks that gauge demand for a bond and are involved in its sale and distribution, would ensure a bond was not only sold to “flippers”.
Even investors with a generally long-term outlook may find the prospect of a quick profit irresistible.
“Even if they are basically long-term investors, they can make 2.5 points within a week by flipping. You have to ask yourself what part of the life of this bond will ever make you a return like that,” said Jeremy Brewin, head of emerging debt at ING Investment Management
He bought both Kenya and Ecuador, saying of the latter: “It’s as good if not better than many Central European or Latin American credits.”
The Kenyan and Ecuadorean bonds both qualified for inclusion in the benchmark JPMorgan bond indices. Kenya’s $2 billion maiden issue of five- and 10-year bonds was overwhelmingly bought by fund managers, with insurance and pension funds buying 6 and 4 percent of the two issues respectively.
“It’s in the index, everybody has to have Africa,” said Stephen Bailey-Smith, head of Africa research at Standard Bank.
Does that mean issuers of bonds likely to end up in the benchmark indexes end up borrowing more than is good for them?
“You sometimes get people coming along saying they want to borrow 300 million and they’re told the order book is five times so they go, ‘I might as well borrow a billion then’. You can’t blame them for doing that,” said Colm McDonagh, head of emerging market debt at Insight Investment, which is part of BNY Mellon.
“It’s more prevalent in the corporate world but to a certain extent you can see that happening in the sovereign world.”
But if things do go wrong and buyers of riskier bonds want out, there are specialists waiting in the wings.
“If you look over the last 30 years, we have had Latin American debt crises, you get periodic events where things go badly wrong,” said Doherty at Tideway Investments. “But in general there is a pretty well functioning stressed and distressed [debt] market.”
(Reporting by Marius Zaharia, Sujata Rao, Carolyn Cohn, Chris Vellacott and Nigel Stephenson in London and Daniel Bases in New York; editing by Janet McBride)