Pursuing Emerging Market Bonds

A bond is a loan; the buyer gives money to the issuer, and then the issuer repays the loan over time. Each interest payment is known as a coupon, and the bond's price at issue is known as the principal. The interest rate at the time the bond is issued is called the coupon rate; after the bond is issued, the price goes up and down so that the realized interest is in line with the market rate of interest. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up. That relationship holds in every market in every time period.

No matter the market, bonds are less risky than stocks because the bondholders are first in line for cash. If the issuer goes bankrupt, those who own bonds are paid before any money goes to shareholders. But keep in mind that investing in emerging markets is riskier than investing in a developed market, so emerging market bonds may have risk that's closer to Fortune 500 equity. If that risk is just right for you, the following sections help you understand how bonds work in emerging markets.

Key bond categories

Bonds come in two flavors: government and corporate. They differ not only based on who issues the bond but also based on how they trade and what happens when and if the issuer can't pay. Here are the basics:

  • Government bonds: In many emerging market countries, the government is the primary economic agent. It may own utilities, banks, and construction firms because the private sector is too small to provide these services. One way to invest in the growth of the country's economy is through bonds issued by the government itself, also known as sovereign debt. Government bonds tend to trade in large volumes and generally have less risk than corporate bonds in the same market. They have some of their own risks, though, which I cover in the later section "Noting the effects of inflation on bonds."

    Debt issued by foreign governments is often used to pay U.S. and European contracting companies for their infrastructure development services. If you're interested in investing in emerging market infrastructure, you may be able to do it with engineering and construction firms that are based in major markets but that draw much of their revenue from emerging markets. You can do some basic screening on a financial website such as Yahoo! Finance if you're looking for the names of such companies.

  • Corporate bonds: Corporations issue corporate bonds to finance their growth and expansion. Many companies prefer to use debt rather than equity to expand because in many countries, interest expenses are tax-deductible, and as long as a company doesn't go bankrupt, debt allows the current owners to stay in control.

How to match bonds and currencies

Bonds have a lot of exposure to changes in exchange rates. When you hold a bond, every time the borrower makes an interest payment or repays the principal, you receive cash. If you need to exchange that cash, then the value of every payment will change based on what the exchange rate is at the time that you receive your money.

If you don't like that risk, you can own a diversified portfolio of bonds in different currencies, or you can buy an emerging market bond that's priced in your own currency. Many governments and large corporations want investors in other countries to buy their bonds, so they often sell bonds in U.S. dollars, euros, and yen. So if, for example, you want to invest in Brazil but don't want exposure to the real (the Brazilian currency), you can buy Brazilian government dollar bonds.

The effects of inflation on bonds

One way for a government to pay off its debts is to pay back the debt with cheaper money; a government has the ability to create inflation (for example, by printing more money) in order to accomplish this goal. Your return is reduced, but the government's leaders have the satisfaction of keeping their reputation for repaying their bills. Hence, one risk you must factor in as a buyer of sovereign debt is that the money may get repaid with funds that are less valuable when converted to your home currency.

Inflation is a bigger risk for government debt buyers than default is. (See the next section for more on bond default.)

Inflation is okay in small doses, but in massive quantities, it drowns an economy and sinks the value of a market's bonds. Any amount of inflation causes a currency to depreciate relative to other currencies, all else being equal. The higher the inflation, the lower your return. Even bonds issued in your currency are affected by inflation because it reduces the purchasing power of the principal and interest payments.

One way to evaluate the risk of bonds in an emerging market is to look at the percentage of debt that a country has relative to its gross domestic product (GDP). The higher that number, the more likely a nation is to try to inflate its way out of debt.

How to deal with default

When a company or government can't pay the principal or interest on its loans, the bond goes into default. With a corporate bond, the bondholders will press the company to come up with a plan to pay off the debt or to liquidate the company. The exact process and legal remedies vary from country to country, but you stand a chance at getting some money back. Keep these points in mind:

  • Seniority: Whether the troubled bonds are issued by a corporation or a government, your first question is whether you, as an international investor, will be treated the same as investors who live in the country. The order of repayment in bankruptcy is known as seniority, and it's possible that citizens are senior to outsiders.

  • Difference between defaults of corporate versus government bonds: Foreign governments may default on bonds, but the governments won't go away. They have to come back to borrow money or otherwise deal with the financial markets, so they have to somehow make good to their creditors. Exactly how and when, though, is a tricky question. With corporate debt, on the other hand, bondholders may be left with nothing after the bankruptcy process is finished.

    With government debt, the International Monetary Fund (IMF) often directs the restructuring of government bonds that are in default. The IMF works with major creditors, which are often other governments, to try to find a way to make sure that the debt is repaid without excessive inflation or hardship. The folks at the IMF don't always succeed, though, and they're not always loved for their efforts.

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