The Bond Market Prefers Dictators to Democraciesby
El Salvador defaulted last week, while Venezuela paid bonds
Political gridlock poses risk to market-friendly governments
Dictatorships are on a hot streak in the bond market.
In the past year, sovereign notes from emerging markets under autocratic rule have returned 15 percent on average, compared with just 8.6 percent for securities from developing countries considered democratic, according to data compiled by Bloomberg. They also have better returns over the past two years, though beyond that the advantage fades.
For all the ugliness that often comes with authoritarian governments -- the human rights abuses, the curbs on free expression -- they often can be very rewarding for bondholders willing to turn a blind eye to those things in exchange for the stability that they can foster.
This isn’t necessarily a brand-new phenomenon, of course, but a pair of events last week served as a reminder of the outsize gains and losses it can trigger. On April 12, Venezuela’s creditors reaped large returns when President Nicolas Maduro made good on $2.5 billion in debt payments even as he struggles to come up with enough money for food imports. Two days earlier, El Salvador, a democracy for the last quarter-century, defaulted as a feud between the president and an opposition party -- a "high-stakes game of chicken," as Nomura Holdings Inc. strategist Benito Berber called it -- left the government unable to make a $29 million payment to a local pension fund.
"Investors typically view the bonds of an autocratic regime very negatively and assign a very high default probability," said Victor Fu, the director of emerging-market sovereign strategy at Stifel Nicolaus & Co. But "in an autocratic regime, the government remaining in power is considered more important than people’s welfare. Since a bond default likely will raise the risks for the government to be thrown out, the ruling party will do its best to prevent a credit event."
Over the past year, investors in sovereign dollar bonds from Venezuela pocketed 55 percent returns. That’s more than the 34 percent from Ghana, the top-performing democratic nation. In fact, bonds from 10 of 15 governments labeled “not free” by Washington-based Freedom House returned at least 10 percent these past 12 months, compared with a third of bonds from emerging-market countries the watchdog organization labels as “free.”
Non-democratic states can take many forms, according to Freedom House. In Azerbaijan, President Ilham Aliyev succeeded his father and has clung to power via three questionable elections. Meanwhile, royal families in Qatar, Oman and Saudi Arabia are among the few monarchies still standing. In Egypt, Abdel Fattah el-Sisi rose to power after a coup in 2013.
Turkey, which Freedom House deems "partly free," may be the latest example of bondholders benefiting from a turn toward one-man rule. The increasingly autocratic government under President Recep Tayyip Erdogan has proven creditor-friendly, according to Fu, with its sovereign dollar bonds outperforming the emerging-market average in 2017 after a wave of credit-rating downgrades fueled a sell-off late last year.
Of course, the rally in bonds tied to dictatorial governments is in part a reflection of the recent hot stretch for the riskiest assets -- democracies tend to have better credit ratings. While emerging-market notes from nations under autocratic rule have outperformed those under democracies by an average of 5 percentage points over the past two years, bonds from democratic nations have the edge over three years and five years.
Latin American Fault Lines
El Salvador’s debt troubles serve as a warning sign for investing in other Latin American nations that -- on the surface -- appear to be market-friendly.
New technocratic presidents have come to power over the past 18 months in Argentina, Peru and Brazil, but they did so under a period of heightened polarization that may pose risks to governability, said Sean Newman, who helps oversee $1.5 billion in emerging-market assets at Atlanta-based Invesco Advisers.
Argentina’s Mauricio Macri and Peru’s Pedro Pablo Kuczynski were sworn in with a minority in congress. And while Michel Temer’s PMDB party in Brazil holds the most seats in the senate and lower house, it must contend with more than two dozen other parties. These slim majorities or minorities in the legislature make bipartisan support essential to the passage of financial measures, including those related to servicing debt.
And the case of El Salvador highlights how quickly everything can go south amid gridlock. Fitch Ratings said the missed pension payment constituted a default on its sovereign obligations and S&P Global Ratings warned "selective default" looked inevitable. The government has said the money for its overseas bond payments has already been budgeted.
"This political gamesmanship really boils down to where the parties want to position themselves ahead of the election next year," Newman said. "It’s certainly decreased our confidence in their ability to get rudimentary measures approved."
That’s less of an issue in Venezuela. Maduro and his allies have throttled attempts by the opposition-controlled congress to hold a recall election against him. And while the president would be an underdog in national elections next October, some observers question if they’ll even be held. Continuing to service the nation’s debt has been key to Maduro holding onto power and investors who have put their faith in him have profited mightily.
In fact, Venezuelan debt has returned more than 770 percent since the socialist Hugo Chavez was elected president in late 1998, beating the emerging-market average of 462 percent.
Under dictatorships, investors usually have better insight into who the actual policy makers are and how they’ll treat bondholders, according to Steve Hooker, a Hartford, Connecticut-based emerging-market money manager at Newfleet Asset Management LLC, which oversees $12 billion. That’s in contrast to democracies, where investors might need to get into the heads of dozens of politicians and bureaucrats who have a say in policy, he said.
Of the six emerging-market nations to default in the 21st century, none were categorized as full-out autocracies by Freedom House.
The last default from a country currently classified as not free was Russia. With Brent crude trading close to $10 per barrel, the country defaulted on about $40 billion of its local debt in August 1998, sparking a rout in the ruble that saw the currency lose more than half its value over the next six months. Eventually, out of that mess stepped a former KGB intelligence officer from St. Petersburg named Vladimir Putin.
“Obviously, investors love Russia with Putin in power," Jim Barrineau, the co-head of emerging markets debt for Schroder Investment Management, said Monday on Bloomberg TV. "It’s not necessarily the case that it’s a necessary and sufficient condition that there be democracy.”