Tuesday, September 9, 2014

Frontier Bonds Wear Parachute Pack

At the frontier of the world's bond markets, high risk sometimes comes with a safety net.

Take Ghana. The African nation is pushing ahead with plans to issue at least $1 billion in dollar bonds as it negotiates a bailout package from the International Monetary Fund. Profligate government spending ignited high inflation and a currency plunge earlier this year. Yet existing bond investors are being spared. Ghana issued $750 million of dollar bonds just last July and word of the IMF's help has sent prices of those bonds rallying.

Issuing bonds along with an IMF program isn't unprecedented. Pakistan received a $6.8 billion IMF package in September 2013, and within weeks had marketed a new dollar bond. It eventually sold $2-billion-worth in April.

Investors like the comfort of IMF programs, which come with promises of reform, curbs on government spending and too-low interest rates. Getting countries back on their feet with access to financial markets is laudable. The question is whether governments will really change without the real threat of default.

Mongolia, which issued its maiden sovereign dollar bond in 2012, has had five IMF programs since 1991, the latest winding down in 2010. Yet macroeconomic management remains spotty. The IMF supported implementation of a fiscal deficit target of 2% of GDP, which the government now meets only by the strictest definition. Spending through a government development bank recently brought the real budget deficit closer to 10%. Extremely loose monetary policy and a plunge in foreign direct investment have unleashed inflation and drained currency reserves.

Mongolia recently negotiated an expanded currency swap line with China's central bank to give it breathing room. Interest-rate increases have reduced jitters, too. Mongolia's five-year dollar bonds due in 2017 now sport a yield of 5.97%, down from as high as 7.9% in February.

But risks remain that resource-rich Mongolia will need a helping hand further down the road, especially if it fails to attract foreign direct investment. Its currency has lost nearly a third of its value against the dollar since the start of 2013.

While a sixth IMF program isn't certain for Mongolia, as in Ghana's case, it seems a bailout would be more likely than letting the market teach this developing nation a lesson. Unlike Greece, where bondholders took a hit, the stakes are smaller. And, unlike Argentina, which hasn't completed required consultations with the IMF in over six years, Mongolia remains on good terms with the international institution.

While the IMF might provide a floor on default, what it can't protect investors from is regular old interest rate risk. Mongolia's bonds were among the hardest hit during the Taper scare last year. Spreads over comparable Treasurys are more than 2 percentage points below their peak.

For investors who aren't holding until maturity, that leaves plenty of room for error.

Write to Alex Frangos at alex.frangos@wsj.com

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