GMHLY Gam Holding Ag (PK)

By James Mackintosh 

When Argentina issued a 100-year bond last year it was taken by many as a clear case of market froth. Investors could hardly get more enthusiastic about emerging markets than lending money for a century to a country that averaged one default every 25 years since its founding. So with Argentina now asking for an emergency rescue from the International Monetary Fund it looks like the skeptics were right. Right?

Not so much. Anyone who bought the Argentine 100-year when it was issued -- in dollars -- last June has lost 2.5% from the slide in price, but made a profit when coupon payments are included. By contrast, buying the U.S. 10 year or longer Treasury bonds at the same time would have lost money, with the 10-year down 7.1% in price and the coupon not enough to compensate.

"It's easy to say only an idiot would buy this, but you can make decent money from this stuff," said Paul McNamara, investment director for emerging market debt at GAM International Management, part of Switzerland's GAM Holding. He prefers Argentine local currency debt, which is shorter-dated but adds currency risk.

Investors who rejected Argentina were right that the country was far, far riskier than the U.S. What they missed -- at least so far -- was that investors were pretty well rewarded for that risk last summer. Buyers of Treasurys were barely rewarded at all for the substantial but hidden risks they were taking.

Argentina has been trying to get back on its feet after the catastrophic rule of Cristina Kirchner ended three years ago, and has made a lot of progress. But the perception that center-right president Mauricio Macri was backsliding, combined with the large current-account deficit and low foreign-exchange reserves, left Argentina vulnerable to the recent souring in sentiment towards emerging markets. A rising dollar raises concerns about countries with big current-account deficits, and Argentina is most exposed, along with Turkey.

In return for these risks investors are currently promised an 8.1% yield on the century bond, up from 7.9% when it was issued thanks to the fall in price. That's a substantial premium to the 3.1% available on the 10-year Treasury, or 3.2% from a 30-year.

Sensible investors buy assets that offer a decent reward for the risk taken. In the case of Argentina's dollar bonds, comparing the reward for different assumptions of risk is pretty simple.

It will take a little over 12 years for Argentine bondholders to get their money back via coupons, the basis of a bond-market measure known as duration, which also includes the final repayment at maturity. If your best guess was that it will be 20 years until Argentina defaults again, you expect to make your money back plus eight years of 7.125% coupons -- more than you would get on a Treasury maturing in 20 years, and with the prospect of recouping something after the default too. Even better, the money would be paid earlier thanks to the fat coupons, freeing it up for other investments.

Of course, if you think Argentina will last less than 12 years until its next default, then the yield remains too low to consider the bonds worthwhile, barring a fast recovery from default.

Owners of Treasurys have nothing to fear from default, since the U.S. government borrows in a currency it can print. But investors are much more exposed to falls in price if yields rise, and low starting yields mean it will take longer to recoup any price drop by clipping the coupon.

Bondholders learned a hard lesson in what they call duration risk two years ago, after yields on long-dated bonds dropped to new lows in the aftermath of Britain's vote to leave the European Union. From its peak in July 2016 the price of the 30-year Treasury dropped 20% in less than six months. It takes many years to make back those losses when yields and coupons are low.

Comparing the reward for duration risk is almost as simple as comparing yields with the number of years until a predicted default. If the yield of the 30-year Treasury rises 1 percentage point, the price will tumble 23%. A similar rise in the 10-year yield will see a loss of 8%, as it has a shorter duration.

Dollar bonds issued by other countries, including Argentina, are also exposed to duration risk, but swings in views about their creditworthiness have a much bigger effect on the price.

Duration danger would come from a belief that secular stagnation was over, and growth and inflation might be sustainably higher, pushing the Federal Reserve to raise its long-run outlook for rates. As with trying to forecast the date of a default, long-term economic forecasting is extremely hard. What we do know is that the reward for these risks is currently very low, because investors are convinced that interest rates will be permanently lower.

The dangers are different, but at least in the case of Argentina they are obvious to everyone.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

May 17, 2018 12:34 ET (16:34 GMT)

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