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Kilian Reber, analyst, kilian.reber@ubs.

com, UBS AG

Wealth Management Research 10 December 2009

Emerging market bonds


Understanding sovereign risk
Fig. 1: Sovereign spreads on decreasing trend
■ Emerging market (EM) sovereign defaults have become relatively rare
Regional sovereign spreads (bps) over US Treasuries
events, trending below 2% of all issuers today. Over the next 1-3 3000

years, overall credit quality in EM should improve further, albeit at a 2500


slower pace.
2000

■ Better economic fundamentals, higher liquidity, and greater political 1500

stability all have improved EM sovereigns' credit quality, leading to 1000


higher returns. This general trend should continue in coming years.
500

■ To benefit from this trend, we recommend a diversified portfolio 0


1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
approach of several different EM sovereign issuers, thereby reducing EMBIG Africa Asia EMEA Latam
Indices are part of the J.P. Morgan Emerging Markets Bond index Global
exposure to country-specific risks. (EMBIG). Source: J.P. Morgan, Bloomberg, UBS WMR as of 10 December
2009

Lending money to emerging market sovereigns has become a much safer


investment compared to 10 years ago. Taking the case of foreign Bond yield spread explained
currency sovereign bonds which eliminates direct local currency risk, The bond yield spread is the difference between
Figure 1 shows that risk premia in the form of yield spreads over US the yields on two different bond investments,
Treasuries have come down considerably during the past decade. After usually of different credit quality. Typically, the
their latest peak following the collapse of Lehman Brothers in September lower the credit quality of a bond is, the higher its
2008 they have largely settled. The figure also shows that the spreads of yield will be, and vice versa. Therefore, when
different sovereign issuers vary much less than they used to – they have comparing a USD-denominated bond's yield to a
somewhat converged over time. virtually "risk-free" bond, such as a US Treasury
note, the difference between the two is the risk
In the following we will show why foreign currency denominated premium that the market demands in order to take
sovereign bonds have become a safer asset class over the last decade, on such an investment.
why they have converged and how investors can benefit from these
trends going forward. Assuming a stable risk-free rate for US Treasuries,
spread widening of a particular bond implies that
the market is factoring in a relatively higher risk of
default for that bond, everything else staying
equal. Conversely, a narrowing of spreads implies
that the market expects a smaller risk of default.
Keep in mind that US Treasury rates are not stable
and may therefore also impact spreads.

This report has been prepared by UBS AG.


Please see important disclaimers and disclosures that begin on page 7.
Past performance is no indication of future performance. The market prices provided are closing prices on the respective
principal stock exchange. This applies to all performance charts and tables in this publication.
UBS Wealth Management Research 10 December 2009

Emerging market bonds

Where's the risk for sovereign bond investors? Table 1: Cases of defaults and resulting losses
The most obvious risk for foreign currency bond investors is the one of Present values of losses after debt restructuring
Year of default Issuer Loss after debt
default, whereby the sovereign fails to service its scheduled debt restructuring in %
payments. Since sovereign nations cannot be liquidated, they typically
1998 Russian 50%
restructure their debt on the basis of less favourable terms, involving a
1999 Ecuador 40%
combination of lower principal, lower interest payments, and longer
1999 Pakistan 35%
maturities, leaving creditors worse off than before. Table 1 shows for a
2000 Ukraine 40%
number of actual defaults from 1998 to 2005 the losses taken by
2001 Argentina 70%
investors after debt restructuring – they ranged from 5% to 70%. Also, 2002 Moldova 5%
even if a large part of the debt in default can be recovered, it may take a 2003 Uruguay 15%
long time to do so.
2005 Dominican Rep. 5%

Hence, for an investor who holds a sovereign bond to maturity, his risk is Overall, issuer weighted 36%
that of the sovereign defaulting on the payments. If the investor Overall, value weighted 59%
considers selling the bond before its maturity, his risk is a that of a
Source: Moody's, UBS WMR as of 10 December 2009
deterioration in credit quality, decreasing the price at which the bond can
be sold. There are other risks factors, but for the moment we focus on
these specifically and show that they are on a declining trend.
Fig. 2: Why it's bad for a sovereign to default
Sovereigns usually try not to default Potential consequences of a sovereign default
Defaulting is usually an option of last resort only. Under normal capital
market conditions, sovereigns actually have strong incentives to repay
their debt – if the necessary financial means are available. A sovereign
faces higher costs and difficulties in getting loans after having defaulted
once, or even worse, repeatedly. Credit ratings tend to be sticky, in the
sense that they "remember" a sovereign's default for a number of years.
A sovereign’s default can potentially lead to a disruption of the country’s
banking system, a currency crisis, further economic contraction, as well as
political disruption, as Figure 2 illustrates.
Source: UBS WMR as of 10 December 2009
Hence, defaulting is usually confined to sovereigns that lack the financial
means to repay their debt obligations or that, for some reason, have
become unwilling to do so. Such unwillingness to repay debt usually
stems from radical political changes, such as revolutions, for example.
Fig. 3: Rarely seen these days: sov. defaults
Defaults have become relatively rare events Number of sovereign defaults in % of issuers
% of all issuers Default ratio of foreign currency bonds
Sovereign defaults are as old as sovereign borrowing itself. Between the 35
16th and the end of the 18th century France and Spain were the leading
30
defaulters, with a total of 8 and 6 defaults, respectively. In the 19th
25
century, sovereign defaults were quite common events, as Figure 3
20
illustrates. In some cases, these were the by-products of wars,
revolutions, or civil conflicts that made sovereigns unable or unwilling to 15

pay. Russia (1917), China (1949), and Cuba (1960), for example, all 10

repudiated their debt after revolutions or communist takeovers. In most 5


cases these were the result of a growing number of sovereign issuers 0
looking for money, coupled with external economic shocks, as well lax 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Source: S&P, UBS WMR as of 10 December 2009
fiscal and monetary policies, ultimately leading to their inability to repay.
The largest wave of defaults, so far, was triggered by the Great
Depression in the 1930s – it lasted well into the next decade.

Emerging market bonds - 2


UBS Wealth Management Research 10 December 2009

Emerging market bonds

In the past few decades, sovereign defaults on foreign currency bonds Fig. 4: More stable growth and lower inflation
have become relatively rare events, fluctuating below 2% of all issuers. Emerging markets' overall GDP growth & inflation
The main reason is that most sovereigns' ability to repay debt, especially 7 Overall EM GDP growth Overall EM inflation (right) 35

within emerging markets, has improved. The slight recent uptrend in 6 30

Figure 3 has to be relativized: the latest global financial and economic 5 25

crisis, so far, has only produced two emerging market sovereign defaults 4 20

–Ecuador, and the Island of the Seychelles. 3 15

2 10

The four major broad factors that have led to an overall increase in credit 1 5

quality within the emerging markets universe, especially within the past 0 0

decade, – and should continue to do so – are improving economic -1 -5

fundamentals, lower debt burdens, record high foreign currency reserves, -2 -10

as well as overall higher political stability. -3 -15


1996 1998 2000 2002 2004 2006 2008 2010* 2012* 2014*

Improving economic fundamentals as driving factor GDP and inflation rates are weighted according to the country weights in the
J.P. Morgan EMBIG; 2009 to 2014 data are IMF forecasts. As the growth
Emerging market economies have seen a trend of more stable economic leaders China and India only have a small issuance, respectively no issuance
growth as well as lower and more stable inflation rates over the last few in the EMBIG (see weights in the appendix), they are underrepresented in the
economic outlook. Source: IMF, J.P. Morgan, Bloomberg, UBS WMR as of 10
years (see Figure 4). Going forward, the IMF forecasts slightly lower but December 2009

still stable overall real GDP growth as well as more stable inflation rates
for the EMBIG (J.P. Morgan Emerging Markets Bond Index Global)
countries for the next few years.
Fig. 5: Less indebted emerging sovereigns
The stable economic outlook is good news for sovereign bond investors EM's overall external debt in % of GDP
as defaults are much less likely to occur when economic growth is stable 70 EM overall gross ext. public debt EM overall gross ext. debt
and inflation is low – more than 60% of all defaults occured when the
60
output level was much lower than its long-term trend. An example is
50
Ecuador, where falling commodity prices led to a deterioration of the
macroeconomic conditions and, in turn, a default of the sovereign in 40

1999. Stronger economic growth and lower inflation also support a 30


country's trade balance and its currency, both also contributing to a 20
sovereigns' credit quality.
10

Lower debt burden and higher liquidity are key factors 0


1996 1998 2000 2002 2004 2006 2008 2010*
The past decade has not only seen stronger economic fundamentals
within emerging markets, but also lower debt burdens and record high External debt is weighted according to the country weights in the J.P.
Morgan EMBIG; 2009 to 2014 data are Fitch forecasts. Source: Fitch, J.P.
foreign currency reserves. As Figures 5 and 6 show, this trend is expected Morgan, UBS WMR as of 10 December 2009
to continue as emerging market sovereigns shift to more sustainable debt
levels to service their obligations, as well as larger amounts of local
currency debt, albeit at a slower pace. Fig. 6: Cash is now king in emerging markets
EM overall foreign currency reserves
This is important as an economy, no matter how strong and stable, may
210,000 Overall EM foreign currency reserves (% of GDP, right) 24%
still be unable to service its debt, and run a substantial default risk, if it
190,000 Overall EM foreign currency reserves (mn USD, left)
faces liquidity constraints. As a sovereign's debt burden (outstanding 22%
170,000
principal plus interest payments) grows smaller, the easier it becomes for 150,000 20%
the sovereign to repay its debt. Emerging market sovereigns, on the 130,000
18%
whole, have also learnt that, in a crisis, "cash is king", as it boosts their 110,000
16%
liquidity. At the same time, a larger part of their debt is now 90,000

denominated in local currency than foreign currency. These are the main 70,000 14%

reasons why most of emerging markets survived this financial and 50,000
12%
30,000
economic crisis largely unscathed. This trend of better liquidity supports
10,000 10%
ongoing good credit quality within emerging market sovereign bonds 1996 1998 2000 2002 2004 2006 2008 2010*
that are denominated in foreign currency.
Currency reserves are weighted according to the country weights in the J.P.
Morgan EMBIG; 2009 to 2014 data are drawn Fitch forecasts. Source: Fitch,
J.P. Morgan, UBS WMR as of 10 December 2009

Emerging market bonds - 3


UBS Wealth Management Research 10 December 2009

Emerging market bonds

Political stability matters, especially in the long-run Fig. 7: Declining trend in political risk
The past few years have also shown an overall trend of decreasing EIU political risk indicator; low (0) to high (100)
political risk within emerging markets, coupled with more 60
Overall EM political risk indicator (EIU)
investor-friendly policies. This is good news for sovereign bond investors 55
as, apart from pure economic variables, political factors also strongly
50
affect sovereign bond prices. Armed conflicts and changes in the political
legitimacy of government, for example, are among the best early 45

indicators for debt reschedulings. Changes in political legitimacy may also


40
lead to policies that negatively affect the default probability of a
sovereign. An example was the run-up to the presidential elections in 35

October 2002 in Brazil: The candidacy of left-wing Luiz Inacio da Silva 30


caused spreads over US Treasures to more than double within a few days 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

only, based on his remarks in favor of debt repudiation. The political risk indicator ranges from 0 (low) to 100 (high). Source: EIU, UBS
WMR as of 10 December 2009

While country-specific political shocks can never be ruled out, we expect


the overall downward trend of political risk in emerging markets to
continue in coming years. Fig. 8: Yet still a world of difference
Highs and lows in % of EM average 2000-2008
Nonetheless a heterogeneous group Lowest (% of average) Average EM (benchmark) Highest (% of average)
422%
Despite the overall improving and converging trend of emerging market 450% Turkey 389%
400% Panama 361%
fundamentals, one must keep in mind that there are still substantial 350%
Lebanon

differences between countries (see Figure 8). For example, real GDP 300% 245%
China
growth in the past 8 years in the emerging markets listed in the EMBIG, 250%
200%
varied from a low of 34.6% of the average (in Jamaica) to a high of 150%
141%
Ecuador

245% (in China). For CPI inflation, external debt, and FX reserves, the 100% 52% 24%
35% 28% 24% Chile Dom.
ranges are even wider, indicating still dramatic inter-country differences. 50% Jamaica Gabon China Rep.
0%
GDP growth CPI inflation Gross ext. debt Political risk FX reserves
Even within credit quality rating categories there can be large differences, indicator
The chart takes the emerging markets average and shows the highest and
especially as ratings agencies are rather lagging and tend to react quite lowest country figures in % of this average. Note: China only has a very small
weight in the EMBIG due to its low foreign currency bonds issuance. Source:
late to sudden changes in sovereigns' fundamentals. Furthermore, from IMF, Fitch, UBS WMR as of 10 December 2009
time to time, new, previously unrated sovereign issuers may enter the
index while very high credit quality sovereigns may exit the index as they
become developed, thus changing its composition.
Fig. 9: Riskier credit reacts more strongly
EMBIG spreads for different rating classes
Don't forget investor sentiment
An additional source of risk that we have not considerd so far is investor 2000
Collapse of Lehman Composite
sentiment. As investor sentiment rises and falls with the world economy 1800
A rated BBB rated
and its outlook, or even localized events, investors increase and decrease 1600
BB rated B rated
1400
their holdings of risky assets. The more risky an asset is, the more strongly
1200
it is affected by investor sentiment. The convergence of spreads of
1000
different credit quality that we have seen over the past 10 years, seems – 800
to an important extent – to have been driven by an improvement in 600

investor sentiment and, in turn, a larger appetite for risk. 400

200

Therefore, with better investor sentiment, speculative grade issuers are 0


Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09
able to get away with paying risk premia that are closer to those of
Source: J.P. Morgan, UBS WMR as of 10 December 2009
higher rated sovereigns. Conversely, whenever investor sentiment
decreases, spreads – especially for lower rated credit classes – rise. Figure
9 shows this for the collapse of Lehman Brothers: spreads on all
emerging market sovereign bond ratings classes increased following the
collapse on September 15, 2008. But the effect was much more severe
for lower rated credit than for higher rated sovereigns.

Emerging market bonds - 4


UBS Wealth Management Research 10 December 2009

Emerging market bonds

The recovery phase after the collapse of Lehman Brothers shows that Fig. 10: Diversification pays off
investor sentiment has still not yet returned to former levels, as lower Risk (volatility) of different sovereign portfolios
Annualized volatility
rated credit spreads are still much higher than they used to be in 2007. 16%
per no. of sovereigns
15%
The risk of volatile investor sentiment affects all asset classes that bear
14%
risk, but it affects higher rated sovereign debt much less than lower rated
13%
sovereign debt. 12%
11%
How this relates to higher returns 10%
The improving credit quality of emerging market sovereign bonds has not 9%

only led to lower risk premia but also to higher returns. The reason is that 8%

bonds whose credit quality improves over time trade at a higher price 7%
6%
than what an investor had initially paid for them. Another part of this 1 3 5 7 9 11 13 15 17 19 21 23 25
performance is to be attributed to investors' higher risk appetite and Source: Bloomberg, UBS WMR as of 10 December 2009
ensuing demand for emerging market sovereign bonds over the years. It
has to be noted that the upside performance potential of emerging
market sovereign bonds is expected to be less pronounced than in the Fig. 11: Improved ratings trend in the EMBIG
past, as US Treasury yields are expected to rise in the years ahead. Composition of the JP Morgan EMBIG

A well diversified approach pays off 100%


CCC &
Despite the declining trend of sovereign defaults and improving below
economic fundamentals, negative surprises can never be ruled out, 80%
especially as the financial crisis has led to a surge in the fiscal deficit in B rated

some countries. More recent examples for such disruptions are the 60%
political showdown in the Ukraine in October 2009 preceding the
presidential elections, or Dubai's restructuring announcements. The best 40%
BB rated
way to mitigate these risks and temporary setbacks is to broadly diversify
over a large number of sovereign issuers and bonds – across regions and, 20% Investment
to some extent, also across ratings levels. Figure 10 shows the annulized Grade
volatility for different (equally weighted) portfolios that invested in a 0%
varying number of sovereigns since 2003. While the risk taken is still 1994 1997 2000 2003 2006 2009
Source: J.P. Morgan, UBS WMR as of 10 December 2009
rather high when investing in only one sovereign issuer, it rapidly comes
down as the number of sovereign issuers in the portfolio increases. With
a number of 8 to 10 sovereign issuers, the annualized volatility decreases Related research material
to slightly above 11% . We refer investors interested in the more
short-term relative attractiveness of regions and
Hence, investment opportunities that follow a broadly diversified index,
countries to our monthly publication "Investing in
such as the J.P. Morgan Emerging Markets Bond Index Global (EMBIG)
emerging markets".
can greatly diversify risk. As the index captures mostly investment grade
and BB rated sovereign issuers (see Figure 11), overall country risk as well
as risk stemming from deteriorating investor sentiment should be well
contained.

Emerging market bonds - 5


UBS Wealth Management Research 10 December 2009

Emerging market bonds

Appendix
What is the EMBIG? Fig. 12: Composition of the EMBIG
There are two main emerging markets bond indices that are produced by Weights in % for EMBIG USD and EMBIG EUR
Country Weight in EMBIG USD Weight in EMBIG EUR
J.P. Morgan. They are the main references for funds and ETFs that invest
Argentina 1.32% NA
in emerging market foreign currency denominated sovereign bonds. One Belize 0.09% NA
is the USD Emerging Markets Bond Index Global (EMBIG USD). It tracks Brazil 12.88% 5.44%
total returns for USD dollar-denominated debt instruments issued by Bulgaria 0.45% 1.59%

emerging market sovereign and quasi-sovereign entities: Brady bonds, Chile 1.43% NA
China 1.82% 1.74%
loans, Eurobonds. Currently, the EMBI Global covers 215 instruments
Colombia 3.85% NA
across 39 countries. It currently consists of the following countries: Croatia 0.49% 3.54%
Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Croatia, Dom. Dominican Republic 0.21% NA

Rep., Ecuador, Egypt, El Salavdor, Gabon, Georgia, Ghana, Hungary, Ecuador 0.19% NA
Egypt 0.34% NA
Indonesia, Iraq, Jamaica, Kazakhstan, Lebanon, Lithuania, Malaysia,
El Salvador 0.93% NA
Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, Serbia, South Gabon 0.28% NA
Africa, Sri Lanka, Tunisia, Turkey, Ukraine, Uruguay, Venezuela, Vietnam. Georgia 0.15% NA
Ghana 0.23% NA
The other is the EUR Emerging Markets Bond Index Global (EMBIG EUR). Hungary 0.45% 16.82%
Indonesia 6.05% NA
It tracks total returns for euro-denominated, straight fixed coupon
Iraq 0.62% NA
instruments issued by emerging market sovereign and quasi-sovereign
Jamaica 0.10% NA
entities. The EUR EMBI Global currently covers 55 instruments across 16 Kazakhstan 1.70% NA
countries. It currenctly consists of the following countries: South Africa, Lebanon 3.15% NA

Brazil, Bulgaria, China, Croatia, Hungary, Lithuania, Mexico, Morocco, Lithuania 0.46% 6.71%
Malaysia 3.27% NA
Peru, Philippines, Poland, Romania, Turkey, Ukraina, Venezuela.
Mexico 12.57% 8.72%
Morocco NA 0.83%
Pakistan 0.33% NA
Panama 2.25% NA
Peru 2.70% 1.22%
Philippines 7.59% 0.88%
Poland 2.28% 32.24%
Romania NA 2.60%
Russia 10.90% NA
Serbia 0.31% NA
South Africa 1.63% 4.26%
Sri Lanka 0.31% NA
Tunisia 0.21% NA
Turkey 10.12% 11.39%
Ukraine 1.06% 0.71%
Uruguay 1.76% NA
Venezuela 5.28% 1.29%
Vietnam 0.24% NA
NA means that the country is not part of the index. Source: J.P. Morgan, UBS
WMR as of 10 December 2009

Emerging market bonds - 6


UBS Wealth Management Research 10 December 2009

Emerging market bonds

Appendix

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Emerging market bonds - 7

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