By Charles Ross, contributor
Managing Director of Sterling Asset Management Limited, Charles Ross. - File
WHILE we had intended to use this next article to look at how global bonds are traded and some of the issues affecting their liquidity, we have been urged to take the time to explain a few commonly used terms, since an understanding of them is crucial to following news on bonds that is carried from time to time in the financial press.
The first important term is a Eurobond. This is a bond which is a country issues in a currency other than its own - usually a currency that is convertible and much stronger than its domestic currency. For example, the government of Jamaica has, over the past few years, issued a number of Eurobonds denominated in US dollars. Such bonds are traded on the international capital market and can be bought and sold in many different countries. When the government issues Eurobonds, it receives US dollars from the purchasers, the interest payments are made in US dollars and the principal - or face value - of the bonds must be redeemed in US dollars at maturity. The Jamaican government has also issued Eurobonds denominated in Euros, the currency of the European Union. However, the word "Eurobond" has nothing to do with the Euro or with Europe, per se.
Another important term is Investment Grade. This term relates to the creditworthiness of a bond and is a credit rating that is awarded to an issuer by a rating agency such as Standard & Poor's - indicating whether the issuer is believed to have at least an adequate capacity to meet its financial commitments. The ratings which fall into this category on S&P's rating system, are set out below:
- AAA The obligor/issuing entity has an EXTREMELY STRONG capacity to
meets its financial obligations:
- AA The obligor has a VERY STRONG capacity to meets its financial
obligations
- A obligor has a STRONG capacity to meets its financial obligations
- BBB The obligor has an ADEQUATE capacity to meets its financial obligations
From the above it can be seen that the minimum credit rating for an investment grade security is BBB. The designation investment grade is important because there are many institutions in the industrialised world that are, for prudential and fiduciary reasons, restricted by their charters to place funds only in investment grade securities. Securities that are rated lower than BBB are considered to have significant speculative characteristics and are therefore not considered suitable for more conservative portfolios that are concerned with long-term capital preservation. As a result of this, countries or institutions that are rated BBB or higher, have a much larger market open to them, as their securities will be open to investment by the large pool of long-term institutional capital that resides in North America and Europe.
The final term is a Bond Index and, in particular, the Emerging Market Bond Index (EMBI+), published by J P Morgan. A bond index is similar to a stock market index, in that it is a collection of bonds which are selected to be representative of the total population of bonds of a particular class that exists in a specific marketplace. In the case of the EMBI+, this index is meant to be representative of the market for bonds issued internationally by developing countries. It contains a representative sample of these bonds that are valued daily and the value of the portfolio is compared to a base value which probably dates back to the original formation of the index. The changes in the value of the index give an indication of the returns that could be earned in the broad market for emerging countries' bonds, in a similar way that changes in a stock market index give an indication of how the securities in that market are doing.
This index is important because many institutional investors judge the performance of their fund managers by their ability to earn at least the returns of the EMBI+ on their portfolios of emerging market bonds. The imposition of this yardstick encourages many fund managers to simply construct their portfolios to resemble as closely as possible the securities which make up the portfolio of the EMBI+. Although the EMBI+ is meant to be representative of the entire market, it contains a limited number of securities and has criteria which, among other restrictions, place a minimum size of US$500 million on the bonds that are eligible for inclusion in the index. The exclusion of an issuer from the EMBI+ therefore reduces the size of the institutional investor market that will consider purchasing its bonds and this can have an influence on the liquidity and price performance of that country's bonds. Smaller countries like Jamaica are at a distinct disadvantage in this regard.
- Charles Ross is Managing Director of Sterling Asset Management Ltd.
