How to Evaluate Sovereign Debt
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Main Topic: Evaluating Sovereign Debt
This episode was inspired by a listener named Elvis who asked the following question:
First of all great job on you podcast, you always provide fresh and objective point of views in a matter that is easy to understand for rookies in finance.
My question is about countries intrinsic value and how to evaluate countries that are recovering from a financial downturn or bankruptcy (bonds default). Have you ever evaluate countries in the same way than companies to recognize when some countries could be a good investment and when is just plain too risky? Furthermore, what industries or companies within those countries will benefit the most from the financial recovery once a new government gets in place or financial rules are imposed by the IMF for example. A few countries that come to mind are Greece, Argentina and Venezuela.
I decided to dedicate an entire episode to this topic for a couple of reasons.
First, its complex. Second, I have never actually bought the sovereign debt of another country for myself or clients. The closest I’ve come is owning the debt of a certain Commenwealth of the United States.
So, just like most of us, I get to learn something new about a very interesting topic, evaluating sovereign debt. Although I have been successful sourcing ideas in the U.S., at some point, sovereign debt of another country may be on sale.
At a minimum, it’s a good thought experiment: what would I need to know about a country to decide if it’s debt is safe to buy.
So here we go.
My first reaction, before doing any research into the topic was to analyze the country as if it were a business. This is a technique used by Warren Buffett to determine whether the US stock market is reaching extreme valuation levels.. I did an episode on the Buffett indicator which uses GNP compared to the total stock market valuation in episode ___.
So the key to analyzing the safety of sovereign debt would be calculate the same type of ratios for the country that you would for a business.
What types of ratios and data to analyze:
- Debt to Gross domestic product
- Contingent liabilities the strength of the banking sector, pension commitments, and health care costs.
- Have they defaulted in the past
- Inflation – as measured by the countries Consumer Price Index.
As far as which countries to look at, they are typically grouped into three categories: Developed, Emerging, and Frontier
Developed markets consist of the largest, most industrialized economies with economic systems that are well-developed, political stability and an entrenched rule of law.
Emerging markets are in the process of rapid industrialization and often have extremely high levels of economic growth. This strong economic growth can sometimes translate into investment returns that are superior to those available in developed markets. However, emerging markets are also riskier than developed markets with more political uncertainty and economies that may be prone to excessive booms and busts.
Frontier markets represent "the next wave" of investment destinations. These markets are generally either smaller than traditional emerging markets, or are found in countries that place restrictions on the ability of foreigners to invest. Unless you are a gambler, it’s generally a good idea to stay away from frontier markets.
Countries with a higher credit rating is considered a safer investment than a country with a lower credit rating. Examining the credit ratings of a country is an excellent way to begin analyzing a potential investment, although I wouldn’t stop there and ratings are backward looking, not forward looking, per se.
Analyze the Investment Climate of the country you are evaluating by looking at these factors:
The investment climate of the country is important and comprises a number of different factors, including
Looking for more information? Check out these additional resources:
The Economist: Economist Intelligence Unit (EIU)
Ratings: Every country in the world has credit ratings similar to business by Moody’s and Standard & Poors.
Some questions to ask posed by Fitch Ratings Group Managing Director David Riley when discussing the critical factors for evaluating sovereign credit.
- Can a sovereign exercise primary authority over a recognized jurisdiction? More specifically, does it wield the power of violence? Can it collect tax? Does it have the ability to print money?
- What is the probability of default on its public debt? In answering that question past defaults can be useful.
- How willing is the government, not the country, to pay its obligations?
- How much financing flexibility does the nation have? One specific factor is whether or not the country’s currency has reserve status.
- What is the nature of structural factors, such as the level of income and wealth in the nation (for instance, GDP per capita); political and social stability; and the payment and principal repayment record?
- What is the level of macroeconomic stability and the condition of the nation’s external finances? Specific measures include: low and stable inflation; level and stability of economic growth; the state of the balance of payments accounts; levels of foreign debt; and the commodity dependence of the nation.
- What is the condition of the public finances of the nation? Key factors include the budget and debt position; overall interest costs; and the structure of the government’s debts (i.e., what percentage of the debt is in local versus foreign currency and the maturity structure of debts).
- Lastly, what is the nature of the monetary sovereignty of the nation? Fitch considers central bank holdings of government debt, the level and volatility of inflation, and other factors. (One interesting data point that Riley shared with conference delegates is that according to his models, the United States would have to have inflation of 25% to inflate away its debt.)
The point to all this is that evaluating sovereign debt requires extensive study into what goes into making a successful debtor. Even using just a credit rating has been shown to be dangerous. Remember when the ratings agencies rated all those mortgage bonds AAA that were really just garbage about to default?
Professional macro investors like George Soros spend their lives looking at countries and their debt, inflation, and currencies. It’s a learned expertise like any other.
I’m pretty comfortable with answers to these questions as relates to the United States, but not other countries.