Analysis: Trading in sovereign promises-I

SKOPJE, Macedonia, April 22 (UPI) -- Martin Schubert and his New York- (now Miami-) based investment boutique, European Inter-American Finance, in joint venture with Merrill Lynch and Aetna, pioneered the private trading of sovereign obligations of emerging market economies, including those in default. In conjunction with private merchant banks, such as Singer & Friedlander in the United Kingdom, he conjured up liquidity where there was none and captured the imagination of businesses on both sides of the Atlantic.

Today, his vision is vindicated by the proliferation of ventures similar to his and by the institutionalization of the emerging economies sovereign debt market.

The demand is so overwhelming that Geneva-based brokerage firm Trigone Capital Finance created a special fund to provide interested investors with exposure to Iraqi paper. Nor is the enthusiasm confined to this former member of the axis of evil. Yugoslav debt is firm at 50 cents, despite recent political upheavals, including the assassination of the reformist and pro-Western prime minister.

Emerging market sovereign debts are irresistible. Some of them now yield 1,000 basis points above comparable U.S. Treasuries. The mean spread, according to JP Morgan's Emerging Markets Bond Index Plus, is about 600 points. Corporate securities are even further in the stratosphere.

But with frenzied buying all around, returns have been declining precipitously in the last few weeks. Investors in emerging market bonds saw average profits of 10 percent this year -- masking a surge of 30 percent in Brazilian and Ecuadorian paper, for instance. JP Morgan Chase's EMBI Global index is up 19 percent since September 2002.

Nor is this a new trend. The EMBI Global Index has witnessed in each of the last four years an average gain of 14 percent. According to Bloomberg, the assets of emerging market debt funds surged by one-tenth since the beginning of the year, or $948 million -- compared to a net $648 million received during the whole of last year.

The party is on. Emerging market debt is either traded on various exchanges or brokered privately to wealthy or institutional clientele. The obligations fall into categories too numerous to mention: insured and uninsured credits, defaulted or performing, corporate against municipal or sovereign and so on.

A dominant class of obligations is called "Brady bonds" after the former U.S. Treasury Secretary Nicholas Brady. These securities are the outcomes of the rescheduling of commercial bank loans (sometimes defaulted) to developing nations. The principal of the rescheduled debt -- guaranteed by U.S. zero-coupon Treasuries deposited by the original issuer in the Federal Reserve or some other credible institution -- remains to be fully paid. The interest accrued on the principal until the moment of rescheduling is reduced and the term of payment is prolonged.

Brady countries include Venezuela, Brazil, Argentina, Ecuador and Mexico, to name just a few. The bonds have been trading since 1989. Only one Brady bond has ever defaulted (Ecuador). No interest payment was ever missed or skipped.

As Nazibrola Lordkipanidze and Glenn C. W. Ames observe in their paper, "Hedging Emerging Market Debt," the terms of individual Brady packages vary. Individual countries have issued as few as one, and as many as eight different bonds, each of which can vary with respect to maturity, fixed or floating coupons, amortization schedules, and the degree to which principal and interest payments are collateralized.

The market is besieged by -- mostly offshore -- mutual funds managed by the likes of Pacific Investment Management Company, AllianceBernstein, Scudder Investments, MFS Investment Management and Mainstay Investment Management.

Emerging market debt attracted entrepreneurial fund managers who set up nimble and agile shops. Ashmore Investment Management was divested to its current owners by Australia & New Zealand Banking Group. Despite the obvious shortcomings of its size -- limited access to information and research -- it runs a successful Russian fund, among others.

When the British-based firms, Garban Securities and Intercapital Securities, merged late in 1999, they transferred their illiquid emerging market securities businesses into a common vehicle, Exotix. The new outfit's team was poached from the trading side of emerging markets divisions of various investment banks. Exotix brokers the purchase and sale of fixed income products from risky countries.

Maxcor Financial, a broker-dealer subsidiary of Maxcor Financial Group, is an inter-dealer broker of various securities products, including emerging market debt. It also conducts institutional sales and trading operations in high yield and distressed debt. AIG Trading, of the AIG group, maintains a full-fledged emerging markets team. It boasts of "senior level contacts within many central banks, allowing us to provide rare insight."

Other outfits stay out of the limelight and offer discrete services, custom-tailored to the needs of particular clients. The Weston Group, in operation since 1988, is active in the Mexican market. It does underwriting, private placements and structured finance.

Companies such as Omni Whittington have specialized in "debt recovery" -- the placement and conversion of defaulted bank and trade debt from political risk countries. They buy bad debt through a dedicated investment fund, collect on non-performing credits (on a "no cure, no pay" basis) and manage portfolios of loans gone sour, including the negotiation of their rescheduling.

Part 2 of this analysis will appear Wednesday. DISCLAIMER: Sam Vaknin traded in sovereign debt throughout the 1980s. Send your comments to: svaknin@upi.com