Why investors in emerging-market bonds are so attuned to political risk

PAULO GUEDES might not be your first-choice brother-in-law. He is a close adviser to Jair Bolsonaro, Brazil’s populist president-elect, who is wistful for military rule. But if you invest in emerging-market government bonds, Mr Guedes is the sort of person you might want as economy minister, the post he will take up on January 1st. He was co-founder of BTG Pactual, Brazil’s Goldman Sachs. He has a PhD in economics from the University of Chicago. He favours tax reform and privatisation.
Brazil is not the only focus of attention for such investors. This week Andrés Manuel López Obrador, a left-leaning populist, was sworn in as president of Mexico. He has cancelled a $13bn bond-financed airport that is already one-third-built. In November a committee of South Africa’s parliament resolved that the constitution should permit land reform without compensation. Some have begun to worry about what Narendra Modi might do to secure re-election as India’s prime minister next year.
A host of emerging-market political risks seem suddenly to be salient. These are not amenable to being tallied in a spreadsheet. Nor is the curriculum vitae of the finance minister really much use. For bondholders, the worry is that bad politics will lead ultimately to bad debts. When your upside is capped at getting your money back with interest, you tend to worry more about your downside.
To trade emerging-market bonds you need to know two things, says Jan Dehn, of Ashmore, an investment firm: a country’s ability to pay its debts—and its willingness. A spreadsheet is useful when reckoning ability to pay. The debt-to-GDP ratio is a good shorthand. Emerging markets have a lower ratio (the average is 50%) than rich countries (105%), whose bonds are for the most part considered a safe store of value. There is no magic threshold at which default risk becomes acute. But as a practical matter, investors are less jumpy when the debt ratio is stable or falling.
Whether it rises or falls depends on interest rates, GDP growth and the size of the primary budget balance (ie, before interest payments). The more interest rates exceed GDP growth, the bigger the primary surplus must be to stop the debt ratio rising. In this regard, Mexico and Brazil are a study in contrasts. Mexico’s debt ratio is near the average and stable. Brazil’s, at 84%, is large and rising fast.
When ability to pay is in question, a country’s willingness to pay is critical. A government is forced to choose between its debtors and others with a claim on its money, like civil servants and pensioners. A lot depends on the interests of political players. Take Brazil. Mr Guedes’s fiscal conservatism may indeed hold sway with his boss. If it does, will Mr Bolsonaro be able to persuade a fractious congress to reform Brazil’s pension system, a big cause of its fiscal problems? What can he offer in return? Coming up with answers takes on-the-ground research.
This kind of intelligence-gathering is beyond the scope of the ordinary investor. But mutual funds based on benchmarks, such as J.P. Morgan’s emerging-market bond index (EMBI) of hard-currency debt, are broad enough to be considered by the non-specialist. The dozens of countries in the EMBI span a diversity of political risks. And the rewards are handsome. The spread of EMBI bonds over Treasury bonds is around 4.2 percentage points. And because in most emerging markets dollar bonds are not a big part of overall debt, there is little point in selectively defaulting on them.
Crunch points are rare, says Graham Stock of BlueBay Asset Management. Most of the time, things get a little better in some emerging markets, a bit worse in others. Brazil is different, however. If it does not take action quite soon, its debt ratio will spiral upwards.
Though this sort of binary (will-they-won’t-they?) political risk is now uncommon in emerging markets, it is increasingly present in the rich world. The euro’s viability depends largely on whether Germany and the zone’s other high-saving countries can agree to some form of fiscal union with others, notably Italy, whose debts loom larger.
At least, say the specialists, you are paid a premium for bearing political risk in emerging markets. It rankles that America has incurred no penalty for policies—a big unfunded tax cut; protectionism—that would sink a poorer country. That Steven Mnuchin, the treasury secretary, is also an alumnus of Goldman Sachs was no bar to recklessness. Something to bear in mind as Mr Guedes and his boss ready themselves for office.