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When the going gets tough, go exotic

AllianceBernstein  |  07 Sep 2016Text size  Decrease  Increase  |  

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For investors with appropriate risk profiles and research insights, Mongolian and Sri Lankan bonds offer intriguing possibilities, according to AllianceBernstein.


Whether investing globally--or with a particular regional focus, such as Asia, or sector focus, such as emerging markets (EM)--investors can benefit from taking both a top-down and bottom-up view of portfolio construction.

A top-down approach is helpful in understanding broad investment themes and trends that cut across sectors and geographies, and in providing a general idea of where to look for opportunities and where risks might be present.

Bottom-up research focuses less on themes and trends and more on specifics. In the case of fixed income, this can mean the economic and regulatory policies of a particular country's government, the structure of its bond markets and the creditworthiness of individual bond issuers.

Together, these approaches can sometimes result in unexpected and apparently counter-intuitive insights which, despite (or perhaps because of) not being obvious, have the potential to add value to a portfolio.

For example, our on-the-ground, bottom-up research has recently led us to build positions in the bond markets of two countries that most investors might regard as exotic.

Wild frontiers

Mongolia and Sri Lanka are "frontier markets", because they haven't yet reached a stage of development that would entitle them to emerging market (EM) status.

Mongolia in particular is small, with a population of just 3 million and nominal GDP at end-2015 of US$11.7 billion.

Sri Lanka has a population of about 21 million and nominal GDP of US$82.1 billion.

Both are sub-investment grade credits, with the former rated B- with a stable outlook by Standard & Poor's (S&P) and the latter rated B+ with a negative outlook. Two other major rating agencies--Moody's Investors Service and Fitch--also have negative outlooks on Sri Lanka.

Mongolia's narrow economic base--the traditional activities of agriculture and livestock and more modern, large-scale mining projects, mainly for export--leaves it exposed to external events.

The country went into a deep recession after the Soviet Union, on which it relied heavily for subsidies, collapsed in 1990-1991, and it was hurt by the Asian financial crisis of 1998-1999.

More recently, the fall in demand for copper, coal and other commodities as a result of China's economic slowdown has also taken its toll.

Sri Lanka's history since achieving independence from Britain after World War II has been scarred by a number of insurrections and outright civil war.

With a relatively diverse economy (including tourism, tea exports, textiles and rice), however, it has made solid progress in reducing poverty.

S&P recently lowered its sovereign risk rating for Mongolia from B on expectations of lower growth in 2016 (1.3 per cent, down from a previous estimate of 2.6 per cent) mainly because of a weakened fiscal position--a hangover from the fiscal expansion that took place when commodity prices were high and inward foreign direct investment flows were strong.

Earlier this year, the rating agency revised its outlook on Sri Lanka's rating from stable to negative because of rising fiscal and external imbalances.

In light of this top-down information, neither country looks particularly appetising from an investment perspective.

So what are the bottom-up insights which, in our view, make the countries' bonds worth buying?

A 450bps rate rise

While it's true that Mongolia's finance minister said recently the country was in a state of "economic crisis," his words need to be seen in context.

Rather than saying anything new, he was in fact referring to conditions that existed before his government came to power in June.

As new governments so often do, he was laying blame for the country's problems squarely at the feet of the previous regime and underlining the seriousness of the situation, the better to prepare the electorate for tough fiscal and economic reforms.

The good news is that the new government--led by the Mongolian People's Party, which won a landslide victory over the previously ruling Democratic Party--has swung into action quickly.

It's cut the salaries of managers and executives in state-owned enterprises by 30 per cent for those earning up to 10 million tugrik (US$4,400) a month, 50 per cent for those earning up to 30 million and 60 per cent for those earning more.

Similar measures affect senior government officials, such as provincial governors.

Shortly after the cuts were announced the Bank of Mongolia raised interest rates by 450 basis points to 15 per cent (nominal GDP growth was 2.2 per cent in the second quarter of this year) to put a floor under the currency, which has depreciated by 11 per cent since July.

The government has also launched a review of the Development Bank of Mongolia (a key vehicle for off-balance sheet spending in the past) which will look at how the bank is funded and how it makes disbursements. Major fiscal reforms have also been flagged for the 2017 budget.

These policies were announced even before a fresh round of talks with the International Monetary Fund (IMF)--which has bailed out Mongolia several times in the past--began.

The signs are that the new government is serious about reform and improving the country's fiscal position.

Foreign investors in Mongolia's external bond market have reacted positively. No doubt they, like us, see the potential for a new Rio Tinto (ASX: RIO) mining project to boost the economy when it comes on stream in the next few months.

A new IMF program would also be a boost for the bond market.

The governor's agenda

Sri Lanka and the IMF are already working together, under an agreement reached in April which granted the country a US$1.5 billion extended fund facility.

The bond markets reacted favourably, seeing it as a first step towards economic stability.

The road may not be smooth. A key feature of the IMF program is structural fiscal reform, including an increase in the country's value added tax and a tightening of revenue collection methods. At 12 per cent of GDP, Sri Lanka's collection rate is low even by EM standards.

Implementation to date has been frustrated, however, by the country's Supreme Court, which has ruled that the proposed increase is not in compliance with the parliamentary legislative process.

At this stage, it appears that the process will need to start again from scratch.

In other respects, policy makers continue to demonstrate a willingness to carry out reforms. The new governor of the central bank, for example, recently raised interest rates, but we think this could prove to be a positive rather than a negative for bondholders.

On a recent research visit to the country, we learned the governor's intention was to signal to the markets that the central bank under his leadership will take a more pre-emptive and forward-looking approach to setting policy.

There are no expectations of further rate rises in the near future.

Asia bonds, currencies are relatively stable

From a top-down perspective, we see the risks to fixed-income investors in Asia as broadly balanced.

Post Brexit, more interest-rate easing is likely across the region--a positive for bondholders, generally speaking.

Against a background of low growth and inflation in developed markets, Asian currencies may continue to benefit from foreign-investor inflows, although we suspect policy makers in the region will take steps to prevent any significant currency appreciation.

One of the risks we're monitoring closely is that of significant fiscal expansion, which could increase government bond supply, potentially putting downward pressure on bond prices and upward pressure on yields.

At this stage, we remain broadly comfortable with fiscal policy in the region.

In this context, a reasonably detailed, bottom-up understanding of economic and fiscal developments in different countries can bring to light opportunities that a broad-brush approach would not detect.

Mongolia and Sri Lanka are two such examples, in our view.

On the basis of our bottom-up insights, we have initiated opportunistic positions in Mongolian US-dollar sovereign bonds and added exposure to Sri Lankan domestic bonds and currency at attractive levels.

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Brad Gibson is a portfolio manager, Asia-Pacific fixed income, Jenny Zeng is a portfolio manager, Asian credit, and Vincent Tsui is an economist, Asia-Pacific, at AllianceBernstein. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

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