Rwanda's Junk-Bond 'Dash for Trash'
Although low interest rates haven't conquered unemployment in the rich world, they're having a big impact elsewhere. Junk spreads are exceptionally low and the issuance of bonds with weak underwriting standards has soared. Yield-starved investors are gobbling up new "covenant lite," "payment in kind" and "dividend recapitalization" bonds at a faster pace than during the credit bubble.
One recent beneficiary of this "dash for trash" is the small landlocked country of Rwanda. Last week, the government of Rwanda sold $400 million in dollar-denominated 10-year bonds at an annual yield of just 6.875 percent and a bid-to-cover ratio of nearly 10. (Typical U.S. sovereign debt auctions have a bid-to-cover ratio between 2 and 3.)
It's the first time Rwanda has borrowed in the international capital markets. This might turn out well, but it could end badly both for the investors who bought the bonds and the nation that issued them.
Make no mistake: Rwanda has an enviable and hard-earned economic record. Output has grown at an average annualized pace of more than 8 percent since the beginning of 2004. This is despite having few natural resources available for export.
One reason is the quality of the country's institutions. President Paul Kagame has consciously tried to turn Rwanda into "the Singapore of Africa." According to the World Bank, Rwanda is an easier place to start a business than the U.S., a better place to borrow money than Sweden, a safer place to invest than France and a simpler place to pay taxes than the Netherlands.
Rwanda plans to use the money it has raised from the bond issuance to repay some existing bank loans and invest in infrastructure. This will save the government money if the interest rate on the bank loans is higher than the yield of the bonds.
Strikingly, Rwanda declined to borrow enough ($500 million) to have its debt included in JPMorgan Chase & Co.'s index of dollar-denominated emerging market bonds, which could have led to lower borrowing costs.
According to the Financial Times, someone close to the deal explained that the Rwandan government was more concerned with being "prudent" than being "index tourists." (Still, the deal is equivalent to about 6 percent of Rwanda's GDP.) The government wants to make it clear that Rwanda is a serious country worthy of investment.
Although the bull case is compelling, investors have plenty of reasons to be wary. Despite years of rapid growth, Rwanda is still very poor. About half of the population lives below the poverty line, while 90 percent of the workforce is engaged in what is mostly subsistence agriculture.
As a result, the country is heavily dependent on foreign aid, which covers about 10 percent of gross domestic product. This income stream isn't dependable. Last summer, several Western donors withheld promised aid because of concerns that the Rwandan government was supporting rebels in the neighboring Democratic Republic of Congo.
The biggest problem of all is that Rwanda is borrowing in a currency it cannot print. Many countries in the euro area have had unpleasant firsthand experience with this over the past few years. Since the Rwandan franc has been declining against the U.S. dollar for years, the real burden of the dollar debt could rise far faster than Rwanda's capacity to service it. At any point in time, lenders could panic about Rwanda's ability to pay and pull their money out. That in turn could strangle business investment and consumer spending, plunging the economy into depression.
Rwanda does earn some hard currency by exporting coffee and tea. The prices of those commodities are very volatile, however. Moreover, any global downturn that affected the willingness of international investors to commit capital to Rwanda could coincide with declining demand for those exports. Ideally, Rwanda would hedge this exposure by indexing the coupon payments on its bonds to the prices of these commodities, as Michael Pettis suggested in his brilliant book "The Volatility Machine."
The broader question is whether this money is flowing to Rwanda for the right reasons. As Pettis noted in that book, the flows of capital between rich and poor countries are generally determined by the domestic conditions in the rich countries, rather than the quality of the investment opportunities in the poor ones.
Right now, liquidity in the rich world is abundant, just as it was in the 1970s and early 1990s. While Rwanda may turn out to be a brilliant success story deserving of foreign investment, it should be wary of those earlier episodes.
Moreover, Rwanda is far from unique in its ability to borrow at very low cost for extremely long maturities. Panama has issued dollar-denominated bonds that won't mature for 40 years, yielding less than 5 percent. Lebanon, which may soon have to deal with spillovers from the ongoing turmoil in Syria, has sold more than $1 billion in debt lasting 10 to 15 years at a lower interest rate than Rwanda.
Despite this seemingly headlong rush into anything with a positive real yield, there are still some lines that investors will not cross. The Wall Street Journal recently reported that Sallie Mae failed to sell bonds backed by particularly dubious student loans at the price that it wanted.
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