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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Argentina, its famous 100yr Bond, and a great example of that old MATURITY versus DURATION thing .....

May 14, 2018

 

ref :- "It is too soon to mock Argetina's century bond" , The Financial Times, Markets and Investing, 11/5/18

 

ref :- "How Argentina went from selling 100-year bonds to an IMF rescue in a matter of months" , QUARTZ (qz.com) 12/5/18

 

 

Oh dear, it all looked so optimistic, too ..... In June of last year, Argentina sold $2.75 billion of US dollar-denominated bonds with a coupon (interest rate) of 7.125% and a maturity date one full century later in 2117. Argentina has a truly dreadful history in capital markets ...... it has defaulted on its debt no less than eight times over the last two centuries, including the largest ever sovereign default as recently as 2001. With that kind of record, one might wonder who on earth would want to lend money to such a serial basket-case FOR SO LONG  --  such a sceptical response was certainly quite prevalent in certain quarters at the time.

 

And yet ..... not only did Argentina successfully get its 100yr bond issue away, it was oversubscribed nearly four times over. After years of the populist, heavy-spending policies of the left-wing president Cristina Fernandez de Kirchner, the disciplined and market-friendly plans of her successor Mauricio Macri plainly impressed investors, some of whom may have been unable to resist the fat coupon on offer in a world of super-low yields. As Argentina is forced once again to go cap in hand to the IMF, an institution loathed by many Argentines for its imposition of strict austerity measures in the past, the sceptics are resharpening their knives.

 

We don't know whether the IMF will grant the $30billion credit line that Argentina seeks, or on what terms. It may be weeks or even months before we do. And even if the request is successful, we are also guessing whether the political cost will be such that Mr Macri and his investor-friendly policies are swept from office. As the nation teeters on the edge, the FT article makes the point that those revelling in a torrent of "I told you so"s are still a bit premature . Even with the bond price down at 87, the initial investors in that bond last June are in fact still breaking even. This is because primary buyers (i.e. those who bought on issue) were offered a big discount ..... a purchase price of 90, rather than 100 (or par). The small paper loss that these guys are currently looking at is more than offset by the "carry"  --  the interest earned on the investment .... which with a coupon of 7.125% is considerable.

 

Those looking to issue century bonds, both sovereign and corporate borrowers, quite often offer large discounts on issue as they greatly increase the attractiveness of the investment by shortening its DURATION. On which note :

 

All investors in bond markets have to examine relevant credit risks, but the FT points out that to focus on the 100 year MATURITY of Argentina's bond misses a crucial point : the difference between MATURITY and DURATION, and they do mean very different things. MATURITY , as you would expect, refers quite simply to the date on which the borrower will redeem the bonds. They will do so at a price of 100, or par, which is normally but crucially not always the price at which they were issued.

DURATION is a fundamental concept in bond markets and one of the first things any traders have to get their heads around. So with apologies to the many for whom this is all a bit "Janet and John get involved in the Capital Markets" ....

 

DURATION is often defined as a measure of a bond price's sensitivity to a change in interest rates, measured in years  --  bonds with longer durations are more sensitive to interest rate changes. You can define it from another angle though, and in this instance it's probably more helpful : DURATION is the amount of time it takes to earn back the principal amount originally invested.

 

So, as the FT again points out, nobody bought the 2117 bond with the thought that some distant descendant might be able to get the principal amount back in 2117. The Maturity date is not the key consideration, it's the DURATION that counts ..... and for initial investors, the big fat coupon and the discounted issue price means that the DURATION of this bond was something a little over 12 years.

 

Those heralding a new dawn for Argentina under a responsible administration were able to proclaim a year ago that the strong demand for Argentina's paper, not redeemable for a hundred years, represented the strongest possible faith in the nation. The truth is however that most of those initial investors were only really concerned with the first 12 or 13 years. Of course, if Argentina crashes they may still lose bundles .... but they're not there yet.

 

P.S.  Do have a look at the QUARTZ article for a tidy resumé of what's gone wrong for Argentina, and why optimism is fast turning to dust. It's an unhappy tale of backing away from stringent targets for the nations sky-high inflation (20% last year) and a cut in interest rates to a mere 28%. That's a fantastically high rate of interest by most standards, but not the signal one wants to send if you're trying to convince the markets that getting inflation down is paramount. Cue : a 20% sell-off in the Peso - v - US Dollar this year. The move has been intensified by a rising rate environment globally, but particularly in the US ..... and as the currency tumbles, confidence in Argentina's ability to finance the huge percentage of its global and corporate debt denominated in dollars tumbles along with it.

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