Over the past six months, prices of emerging market bonds including those issued by the Arab countries, have rallied dramatically making them among the best performing asset classes over this period. From a low of 7.3 percent over US treasuries in October 2002, emerging market bond spreads, as measured by the Salomon Emerging Market Bond Index, have now dropped to about 4.3 percent over US treasuries. The returns recorded by Arab bonds in the international market were even higher. Those issued by Egypt maturing in 2011 were up 31 percent in the past 12 months, Qatar’s Eurobonds maturing in 2009 were up 20 percent, Tunisia’s bonds maturing in 2007 were up 12 percent and Jordan’s Brady bonds up 13 percent. As an average, investing in Arab bonds issued in the international market generated total annual returns of 20 percent during this period.
The rally in the Arab bond markets was fueled by several factors including the general decline in international US dollar rates, the end of the war on Iraq and the subsequent willingness of investors to take on more risk and the upgrading of credit risk for Tunisia, Lebanon, Qatar, Bahrain. Interest rates on US government bonds dropped to their lowest level in 40 years. A treasury bond that matures in two years is paying 1.25 percent interest and the one maturing in 5 years, 2.25 percent and in 10 years 3.25 percent. German two-year government bonds are yielding 1.94 percent and 10-year Japanese government bond yields 0.5 percent.
Before we go further, let us get our terms straight. When you buy a stock, you become a partner in a business, an owner. When you buy a bond, you lend money to a business or a government which promises to pay you back on a specific date, with interest as well. In other words, a bond holder is a creditor.
Bonds which are debt instruments that provide a specific interest rate, known as the coupon, fluctuate in price according to the direction of market interest rates. When economic activities slow down and interest rates fall, as they have done since 2000 when the Federal Reserve of the US and the European Central Bank started to lower their respective interest rates, bond prices would rise. Conversely, when the economy is strong, interest rates tend to rise and bond prices would assume a declining trend.
When buying a bond that pays a fixed interest rate annually, the investor incurs an “interest rate risk”. Assuming you pay 1,000 Jordaninan dinars for a new 5-year bond that carries say a 6 percent interest rate, you will get 60 dinars in interest a year. But if rates in the market rise to 7 percent, this means that new bonds will generate 70 dinars in interest a year. No one will pay 1,000 dinars to buy the 5-year bond you have.
The only way for someone to earn 7 percent on your 6 percent bond is to pay you less than 1,000 dinars or about 900 dinars. So if interest rates rise, prices of the bonds you hold would drop and the opposite is true in a declining interest rate scenario. Bond investors have done well lately because interest rates have fallen.
Bond yields are also influenced by creditworthiness and maturity. Bonds backed by the full faith and credit of the US government or other governments from the developed countries have virtually no risk of default. Bonds issued by the governments of developing countries are more risky and therefore should command higher rates than those issued by the US or European governments. Highly indebted developing countries or those with lower credit rating have to pay higher interest rates to attract buyers. Over the past 20 years, for example, a AAA-rated bond has paid an average of about a percentage point more interest than a BBB-rated bond.
Over the past few months the credit standing of several Arab countries has improved. For example, Moody’s upgraded Tunisia’s foreign currency debt to Baa2 citing its stable and resilient economy.
The country’s first quarter deficit narrowed by 17 percent. In Lebanon, Standard & Poor’s revised its sovereign outlook to positive and the EIU adjusted its GDP growth up to 1.9 percent in 2003 and 2.8 percent in 2004, both citing the continued positive effects of the Paris II donor conference on Lebanon’s economy. Qatar took a step closer to democracy with 96 percent of its people approving a constitutional referendum on establishing a new parliament. Meanwhile the country has become a major producer of natural gas adding to its oil revenues. Both developments contributed to the country’s credit appreciation. Jordan’s economic growth which slowed down in the first quarter picked up momentum after the end of the war on Iraq, with the country receiving $700 million in additional aid from the US, while Saudi Arabia, UAE and Kuwait have pledged to provide Jordan with the oil it needs at subsidized prices to replace the loss of Iraqi oil.
Algeria proved resilient despite the human and financial cost ($2 billion estimate) of an earthquake that shook up the capital, Algiers. The country’s increasing foreign exchange reserves and strong oil revenues continue to support its foreign currency debt.
Morocco sidestepped the negative effects of a terrorist attack in Casablanca and a drop in tourism receipts as market participants were encouraged by a positive IMF review and the success of the privatization of Regie de Tabac. GDP is forecast to grow by 5.5 percent this year following a good rainy season. The recent stabilization of the exchange rate market in Egypt boosted investment prospects and improved the country’s overall economic outlook.
Worries over the threat of deflation in several parts of the global economy are surfacing and there are genuine concerns that the weak US economy could be heading toward a damaging downward spiral. Confirmation that the growth outlook remains extremely soft in Germany was enough to persuade the ECB to cut interest rates recently by 50 basis point to 2 percent. The American and German situation today is similar in some ways to that of Japan a decade ago. Like Japan in 1990, the United States and Germany are now facing the aftermath of a huge stock market bubble. Also like Japan, America faces a problem not of sharp downturn but of persistent underperformance, an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization. Japan didn’t have a severe recession until 1998. But year after year, Japan underperformed, growing less than its potential. Though the Japanese government tried to stimulate the economy using the usual tools of deficit spending and interest rate cuts, it was never enough. By 1995 or so the economy had slid into a liquidity trap; by the late 1990s it had entered into a deflationary spiral that is still holding today.
While Germany is already experiencing deflationary pressures, the US is unlikely to have deflation right away. Nevertheless, deflation will continue to be a threat to the US economy in the months ahead and will keep downward pressure on dollar interest rates and bond yields.
Accordingly we continue to anticipate strength in Arab and emerging bond markets, although any increase in bond prices from current levels will no where match the surge of the past six months. Arab bonds would still provide a good investment opportunity for those desperately seeking higher yields.
(Henry T. Azzam is chief executive officer at Jordinvest.)