El Salvador and Mongolia: solid bet, or bubble?

Is El Salvador, a poor Central American country struggling to overcome a violent history, a safer bet than Portugal? And is Mongolia, a country that has been rescued five times in the past 22 years by the International Monetary Fund, a better investment thesis than Spain?

Bond investors seem to think so.

In the latest sign of just how desperate return-starved investors are for incremental yields and their increasing willingness to go down the credit curve to chase them, the two frontier countries on Thursday pulled off issues that stunned the market in both their pricings and take-up rates.

El Salvador raised $800m from international investors with a 12-year dollar-denominated bond. The issue, which attracted $5.1bn in orders, was priced at a yield of just 5.875 per cent. This compares with Portugal’s 10-year bond yield, which currently sits at 7.407 per cent.

Meanwhile, Mongolia, which has been something of a darling among EM investors in recent years but whose shine has been tarnished by weaker global commodity prices and changes to foreign investment rules, succeeded in raising $1.5bn in a two-part offering.

The $500m, five-year tranche sold at 4.125 per cent yield while the larger 10-year $1bn tranche priced at a yield of 5.125 per cent. Spain’s 10-year bond yield is at 5.303 per cent. The Mongolian offering was 10 times oversubscribed, attracting $15bn in bids.

The numbers make for some mind-boggling reading, says Robert Abad, emerging markets specialist at Western Asset Management.

“The Bolivia deal which came out a few weeks ago confirmed that turbo-charged global liquidity conditions are allowing issuers to come to market at yields that are probably half of what they would have had to offer investors if credit conditions were normal”, he told beyondbrics.

“The sub-5 per cent on that particular deal came as a surprise to EM veterans,” he added. “But as we all know, the market has a very short memory, so it is not as surprising to see Mongolia accessing the markets at yields that do not fully capture the risks inherent in a fast growing country with a limited history of managing economic cycles.”

Although Mongolia’s $10bn economy is one of the fastest-growing in the world and the country sits atop vast reserves of copper, coal and gold, Abad said he decided to sit out on the issue.

“In my opinion, these yields reflect very little spread premium, if any, for the risk,” he said.

Not everyone feels that way of course, as the overwhelmingly strong demand for the issue showed.

With returns on investment grade emerging markets such as Mexico and Brazil no longer as attractive as they once were, many investors have started to take their money to riskier places like Zambia, Bolivia and now Mongolia and El Salvador.

“In the case of Mongolia, one way to think about it is would you rather have the financial surpluses but political risk of Mongolia or the euro blow-up risk of Spain?” asks Gabriel Sterne, an economist at Exotix. “I guess the market’s verdict is the former, and I for one wouldn’t quarrel too much with that.

“But if and when the Fed starts tightening, it’s hard too imagine yields staying this low.”

In a market with razor-thin yields, one EM debt banker argued rarity and investors’ desire to diversify their portfolios won the day for both Mongolia and El Salvador.

“Everything is relative,” said the person. “Sub 6 per cent might look cheap for El Salvador but it’s pretty appetizing for investors who are getting 2.53 per cent from Mexico 10-year and 1.61 per cent from US 10-year T-bills.”

But are investors doing their homework? Ultimately, they are making a wager that the countries behind the issues will be able to service their debts. And as the ongoing negotiations over Belize’s default over a $544m bond and the debt restructuring of Saint Kitts and Nevis, the Caribbean island federation, show, governments – when pressed against the wall – won’t hesitate from reneging on their creditors.

The fact that El Salvador was able to pull off its issue at a sub-6 per cent yield is made all the more surprising by the fact that the country was downgraded by Moody’s to “Baa2″, or three levels below investment grade, only last month. (Fitch maintained its “BB” rating on the country with a negative outlook).

In its report, Moody’s called attentioned to El Salvador’s debt, which amounts to 51 per cent of GDP and limits its capacity to resist future shocks.

The US dollar has been the national currency for more than a decade. The country’s export profile is similar to that of its Central American neighbors: the offshore garment and textile industry, tropical fruits and shrimps.

GDP is forecast by Fitch for this year at 1.3 per cent, the lowest in Central America, and FDI is minimal.

The economy is strongly dependent on remittances, which rose 7.2 per cent year-on-year to hit $3.2bn by the end of October. They account for almost a fifth of GDP.

While some critics will point to the two issues as more signs of a bubble forming in the EM debt space, Abad thinks it is nowhere close to bursting yet.

“Rates in the developed world will remain low for some time allowing for more yield and spread compression in risk assets,” he says. “However, because technical considerations are overwhelming fundamentals, the job for investors is to remain disciplined and alert. Without such restraint, they risk chasing yield and falling into an abyss once fundamentals reassert themselves.”

Additional reporting by Ron Buchanan

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