Cross-Border Fixed-Income Investments
The focus of this topic is on cross-border fixed-income investments, a type of investment that carries the risk of investors not receiving the anticipated interest and principal cash flows. These investments are differentiated between international credit markets in developed countries and those in emerging or frontier markets.
Developed vs Emerging Markets
Developed countries typically have well-established and liquid derivative and other capital markets. They feature a wide variety of private and public debt issuers, with bonds denominated in a freely floating domestic or other major currency. This provides a stable and reliable environment for investors. For instance, the US Treasury bonds are a prime example of such investments.
On the other hand, emerging or frontier fixed-income markets are often dominated by sovereign issuers, state-owned or controlled enterprises, banks, and producers operating in a dominant domestic industry such as basic commodities. These markets present a higher risk due to their dependence on a single commodity or industry. For example, the Venezuelan government bonds heavily rely on the oil industry.
Risk and Diversification
It is crucial to note that investments in sovereign, bank, and private sector debt in emerging economies may offer little to no diversification due to the concentrated risk to a particular commodity or industry. This lack of diversification can increase the risk for investors.
Emerging-Market Bonds and Developed Markets
Emerging-market bonds, often denominated in a restricted domestic currency, exhibit varying liquidity levels. Notably, the sovereign government and select domestic issuers often issue global bonds in major foreign currencies like US dollars or euros. It’s crucial to consider these and other individual market differences when strategizing across countries.
For instance, in developed markets like the US, sector composition differences exist. Approximately one-third of the Bloomberg Barclays US Aggregate Bond Index comprises mortgage-backed and other asset-backed instruments, a significantly higher percentage than other developed markets. Investors in developed European and Asian markets seeking commercial or residential real estate exposure might consider covered bonds or indirect exposure via bank bonds where securitization is less common.
International Accounting Standards and Macroeconomic Factors
Differences in international accounting standards between the International Accounting Standards Board’s International Financial Reporting Standards and US GAAP in areas such as inventory recognition, restricted cash, and cash flow definitions necessitate adjustments for financial ratio comparisons across jurisdictions.
While most developed markets face common macroeconomic factors influencing the bond term premium and expected returns, such as inflation, monetary policy, and economic growth, differences in the timing and magnitude of market changes, as well as the credit cycle across countries, often reflect in interest rate differentials, exchange rates, and credit spreads.
Understanding the characteristics and risks associated with emerging markets is crucial for investors. This includes understanding sovereign credit risk, assessing sovereign creditworthiness, and understanding the exchange rate regime.
Characteristics of Emerging Markets
Emerging markets, such as India and Brazil, are characterized by higher, more volatile, and less balanced economic growth than developed markets like the US or UK. They often face greater geopolitical risk, currency restrictions, and capital controls.
Sovereign Credit Risk in Emerging Markets
Sovereign credit risk, the risk that a government will default on its debt obligations, is a critical starting point when considering fixed-income investments in emerging markets. Both the ability and willingness of issuers to repay debt is of importance.
These considerations include a country’s institutional and economic profile, use of monetary and fiscal policy, the exchange rate regime, and external debt status and outlook. For instance, political stability in South Africa or institutional transparency in Mexico can impact their credit risk.
Sovereign governments tax economic activity within their borders to repay interest and principal. Key financial ratios used to assess and compare sovereign creditworthiness are usually measured as a percentage of GDP. A country’s exchange rate regime, such as the floating exchange rate in India, is a critical element of monetary and external flexibility.
Currency Regimes and Emerging Markets
In the freely floating currency regimes allow a currency to be held in reserve outside its home country. This gives sovereign governments the flexibility to pursue an independent monetary policy. For example, the US dollar, a reserve currency, allows the US government to adjust its monetary policy as needed. Conversely, restrictive or fixed-rate regimes, like the Chinese Yuan, limit policy effectiveness, exacerbate the effects of economic crises, and increase the likelihood of financial distress.
Emerging markets are often characterized by non-reserve currency regimes with significant external debt denominated in major foreign currencies. For instance, India, an emerging market, has a significant portion of its debt denominated in US dollars. Analysts often use external debt to GDP and currency reserves as a percentage of GDP as key leverage and liquidity measures of creditworthiness.
SRSK Model
The SRSK model, akin to the DRSK model, allows users to modify model inputs and derive a “model” CDS spread, which can be compared to the market CDS spread. For example, Costa Rica has a 1.28% one-year default risk and a model CDS spread significantly lower than the market CDS spread.
Investors in emerging market bonds issued by private companies should consider several factors. Even though some local companies might have partial private ownership and publicly traded equity, the sovereign government could exercise controlling influence on the business, including replacing management or ownership groups. For instance, in Russia, the government has significant control over major companies like Gazprom.
Credit Quality in Emerging Markets
Credit quality in the emerging market credit universe exhibits a high concentration in lower investment-grade and upper high-yield ratings categories. This concentration of credit ratings is largely a reflection of the sovereign ratings of emerging markets but also reflects the fact that a “sovereign ceiling” is usually applied to corporate issuers globally. This ceiling implies that a company’s rating is typically no higher than the sovereign credit rating of its domicile.
Relative Liquidity Conditions and Currency Volatility
Understanding relative liquidity conditions and currency volatility is crucial for international credit investors, particularly in emerging markets. These markets often encounter liquidity constraints characterized by a limited number of bonds that are regularly traded, which can force investors to demand higher premiums to compensate for the risk of holding less liquid assets. For instance, in markets like Argentina, the apparent liquidity of local bond markets may be deceptive due to inflated trading volumes driven by interbank trading rather than genuine investor activity.
Moreover, emerging markets such as Turkey are prone to significant currency volatility, influenced by restrictive currency regimes and underdeveloped derivative markets. This volatility is reflected in higher Yield to Maturities (YTMs), indicating an anticipated depreciation of the local currency. Despite these financial instabilities, emerging markets offer unique investment opportunities, as demonstrated during the 1997 Asian financial crisis when investors capitalized on discrepancies like the forward rate bias to invest in higher-yielding currencies
Practice Questions
Question 1: Consider an investor who is looking to diversify their portfolio by investing in fixed-income securities. They are considering investments in both developed and emerging markets. In the context of cross-border fixed-income investments, which of the following statements is most accurate regarding the risk and diversification potential of these investments?
- Investments in developed countries offer higher risk due to their dependence on a single commodity or industry, while investments in emerging economies offer a stable and reliable environment for investors.
- Investments in emerging or frontier fixed-income markets are often dominated by sovereign issuers, state-owned or controlled enterprises, banks, and producers operating in a dominant domestic industry such as basic commodities, offering little to no diversification due to the concentrated risk to a particular commodity or industry.
- Investments in developed countries and emerging economies offer the same level of risk and diversification potential as they both feature a wide variety of private and public debt issuers, with bonds denominated in a freely floating domestic or other major currency.
Answer: Choice B is correct.
Investments in emerging or frontier fixed-income markets are often dominated by sovereign issuers, state-owned or controlled enterprises, banks, and producers operating in a dominant domestic industry such as basic commodities. This concentration of issuers in a few sectors can lead to a high degree of risk concentration, particularly if these sectors are exposed to similar economic, political, or other risks. This can limit the diversification potential of investments in these markets. Furthermore, the fact that many of these issuers are state-owned or controlled can introduce additional risks related to government policy and intervention. Therefore, while investing in emerging markets can offer potential for higher returns, it can also involve significant risks and may not provide the level of diversification that an investor might expect.
Choice A is incorrect. It is not accurate to say that investments in developed countries offer higher risk due to their dependence on a single commodity or industry. Developed countries typically have diverse economies with a wide range of industries and sectors, which can provide opportunities for diversification. Similarly, it is not accurate to say that investments in emerging economies offer a stable and reliable environment for investors. Emerging economies can be subject to a variety of risks, including economic instability, political risk, and regulatory risk.
Choice C is incorrect. While it is true that both developed countries and emerging economies can feature a wide variety of private and public debt issuers, it is not accurate to say that they offer the same level of risk and diversification potential. As mentioned above, emerging economies can be subject to a variety of risks that are less prevalent in developed countries. Furthermore, the fact that bonds in emerging economies are often denominated in a freely floating domestic or other major currency can introduce additional currency risk.
Question 2: Accounting standards play a crucial role in financial analysis and decision-making. There are differences in international accounting standards between the International Accounting Standards Board’s International Financial Reporting Standards and US GAAP in areas such as inventory recognition, restricted cash, and cash flow definitions. These differences necessitate adjustments for financial ratio comparisons across jurisdictions. In this context, which of the following is a key difference between International Financial Reporting Standards and US GAAP?
- The way they define and recognize revenue.
- The way they treat inventory recognition, restricted cash, and cash flow definitions.
- The way they calculate and report financial ratios.
Answer: Choice B is correct.
The key difference between International Financial Reporting Standards (IFRS) and US GAAP is the way they treat inventory recognition, restricted cash, and cash flow definitions. IFRS and US GAAP have different rules and guidelines for these areas, which can lead to differences in the financial statements prepared under each set of standards. For example, IFRS uses the First-In, First-Out (FIFO) method or weighted average cost for inventory recognition, while US GAAP allows for the use of Last-In, First-Out (LIFO) method in addition to FIFO and weighted average cost. Similarly, the definition and classification of restricted cash and cash flows also differ under the two standards. These differences can significantly impact the financial ratios and other financial metrics, making it necessary to adjust for these differences when comparing financial statements prepared under different accounting standards.
Choice A is incorrect. While there are differences in the way IFRS and US GAAP define and recognize revenue, this is not the key difference between the two standards. Both IFRS and US GAAP have comprehensive revenue recognition standards that require revenue to be recognized when it is earned and realizable. The specific rules and guidelines may differ, but the fundamental principle is the same.
Choice C is incorrect. The way financial ratios are calculated and reported is not a key difference between IFRS and US GAAP. Financial ratios are derived from the financial statements and are not directly governed by accounting standards. However, as mentioned earlier, the differences in the accounting standards can impact the financial ratios, necessitating adjustments for comparisons across jurisdictions.
Glossary
- Emerging-market bonds: Bonds issued by national governments of developing countries in foreign currencies to finance growth.
- Sovereign Credit Risk: The risk of a government defaulting on its debt obligations.
- Exchange Rate Regime: How a country manages its currency in relation to other currencies.
- Freely floating currency regimes: Currency systems where the value is determined by the foreign exchange market.
Portfolio Management Pathway Volume 2: Learning Module 6: Fixed-Income Active Management: Credit Strategies.
LOS 6(h): Discuss considerations in constructing and managing portfolios across international credit markets