Defaults Hurt, But Emerging Debt Still Wins in the Long Run
The rebound in emerging-market bonds came as the U.S. Federal Reserve retreated from talk of higher interest rates and the dollar fell from postcrisis highs against emerging-market currencies, making hard-currency bonds easier to service. But just as important for investors, emerging-market bonds mostly continued to pay fat coupons at a time when developed-government bonds offer slim pickings.
Those fat coupons are vital. Research on hard-currency bonds since Britain and Prussia defeated France at the Battle of Waterloo in 1815 shows that on average the return from lending to governments issuing external debt in sterling or dollars delivered a return close to U.S. stocks, with lower volatility. Lending to serial defaulters was even more lucrative, because the high rates Western investors demanded more than offset the terrible repayment record of emerging-market debtors, according to a new study by Josefin Meyer and Christoph Trebesch of the Kiel Institute for the World Economy and Harvard’s Carmen Reinhart.
In other words, you’re paid enough along the way to justify the occasional severe capital loss from default—on average, and over a long period. Defaults are less bad than many believe, with only three cases of full debt repudiation in the 20th century (Russia, Cuba and China after their Communist revolutions) and five in the 19th century. Unfortunately, the solid average return conceals long periods where you would have lost money after lending booms turned to bust and stricken governments couldn’t or wouldn’t pay.
The importance of those coupons is brought home by looking at Argentina, which managed to sell a 100-year bond in 2017, despite its terrible record of defaults. Sure enough, the century bond currently trades at 77 cents on the dollar, down 15% from the issue price. But it pays a coupon of 7.125%, so investors who bought at the discounted issue price of 90 cents on the dollar will be in the money again if they wait for this June’s payout, and the price remains unchanged.
Argentina has spent about a third of its history in default on its foreign debt. Yet in 124 years of data and seven defaults tracked by Meyer, Reinhart and Trebesch, Argentine hard-currency bonds delivered an average return of 5.6 percentage points above U.S. Treasurys or U.K. Gilts, despite the haircuts imposed on investors.
It’s reasonable to expect another Argentine default, especially as it is so reliant on borrowing in foreign currencies, which it cannot print. But if the government, helped by the International Monetary Fund, can avoid defaulting for another decade investors should have made enough on the coupons to cover an average restructuring and still match U.S. Treasury returns. Across 313 restructurings since 1815 an average of 22% of the face value of the bonds was wiped out, or a haircut for investors of 38% weighted by the amount restructured.
We should expect the pattern of the past to continue. Countries will continue to borrow too much in foreign currencies when times are good, and to default when their economies sour. Truly long-term investors who can lend for decades without worrying should make a decent return, punctuated by awful periods of loss. Everyone else has to worry about the boom-bust cycle.
It feels like the emerging-market boom was turning to bust last year, before the Fed changed course. But the yield on emerging-market hard-currency bonds isn’t especially high, with the main measure, JP Morgan ’s EMBI Global Diversified Index, yielding 3.5 percentage points above Treasurys. That is down from 4.2 points at the start of the year and in the middle of the range since 2010.
Plenty of risks remain. Companies in emerging countries have borrowed heavily in foreign currencies, debt which might end up being taken on by their governments in a crisis. Across both public and private sectors, emerging countries need to refinance $3.9 trillion of debt by the end of next year, according to the Institute of International Finance, which represents major banks and investors. Populists have come to power in many countries in the emerging world (as well as the developed world), and historically populists have had little respect for the norms of finance. Perhaps worst of all, the Fed might only be on pause temporarily; in recent decades Fed hikes and a strong dollar have often led to waves of emerging-market defaults.
History shows that these dangers tend to be exaggerated, and lending to emerging market governments on average works out. But the reward is there because the risks are genuine, and most investors cannot wait long enough to be sure of the average return.