By Charles Ross, Contributor
Ross
ALL SECURITIES are subject to market perceptions or market psychology, but because emerging markets are thin and not as liquid as those of developed countries, the prices of bonds issued by developing countries can be much more volatile than those of industrialised countries. This means that, in general, we are likely to see much greater and more frequent swings in the prices of emerging market bonds. These changes in price may not be entirely related to changes in the fundamentals of the issuing country or the prevailing level of interest rates, but will be much more heavily influenced by the prevailing market sentiment and the peculiarities of the market for a particular country's bonds. This price volatility will also be influenced by the extent to which traders of the bonds use techniques like shorts and margin in their buying and selling of bonds.
Thomas Friedman in his book The Lexus and the Olive Tree, uses a concept called "the electronic herd" to describe the way in which international capital can flow in and out of countries, depending on how they are viewed by fund managers of the developed world. The herd mentality is a well-developed concept and in today's world, where information is widely available and circulates world-wide almost instantaneously, the impact can be far-reaching. Money moves electronically at almost the same speed as information. Therefore, when fund managers receive and act on information in the same way, the electronic herd effect comes into play, with large amounts of money moving in and out of markets. When this happens to the securities of thin emerging financial markets, the result is sharp and marked swings in the prices of those securities.
The phenomenon of the electronic herd is closely linked to the concept of contagion. Contagion occurs when a crisis or problem in one country spreads to affect other countries which are not suffering from that or any other problem. The Asian crisis of 1998 was a classic example of problems in one or two countries leading to investors losing confidence in the financial markets of almost all developing economies in South East Asia and withdrawing huge amounts of capital from the region. This, of course, led to real economic difficulties in many of the countries - including a fall in the price of bonds of most developing countries - and a period of difficult adjustment ensued before confidence eventually returned to the region. Such developments are proof that upheavals in one part of the developing world can affect countries that are not in physical proximity to those experiencing the problems.
Movement in the prices of a particular emerging market bond depends to a large extent on the peculiarities of the market for that country's bonds. It must be borne in mind that some bonds are traded in much the same way that stocks are traded and this can cause their prices to behave in a similar way to stock prices. When traders take bets on which way a bond's price is going to move by say selling the bond short - that is, selling a bond which they don't own in the expectation that the price will fall and they will be able to buy it back at a lower price and pocket the difference - they add to the volatility of the bond price in a thin market. Their selling of the bond pushes the price down and when they buy the bond back to cover their position, it pushes the price up. Fortunately, not all emerging market bonds are subject to very high levels of volatility and price volatility does tend to decline as the credit rating of the issuing country rises. There are some countries however, with fairly modest credit ratings but which have quite stable and strong bond prices. These tend to be small countries, which have very strong local participation in and ownership of the country's bonds. Local investors tend to buy bonds and hold them, rather than trade them frequently. This leaves a relatively small amount of the bonds in the hands of international institutions and local demand is usually sufficient to absorb any excess supply that develops among the international investors. Costa Rica, Guatemala, Trinidad and Jamaica are some of the countries that fall into this category. This is not to say that the prices of these countries' bonds do not move up and down over time, but the degree of movement is much smaller and less frequent than the bonds of larger countries with the same credit rating.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
