FT Tilt - Political risk premia for frontier bond markets revealed(Registration)

The unexpected onslaught of successive MENA crises this year has shown that political forecasting is a dismal science. What's more, when a crisis does erupt, governance risk premia is nigh-impossible for markets to price since it's based on subjective assessments of the investment risk in a conflict-ravaged economy.

But Exotix have boldly plunged into the debate. On Tuesday, the investment house had a stab on pricing the 'autocracy premia' investors are demanding for holding sovereign bonds in frontier markets, the Middle East and North Africa region, especially.

According to their country-by-country model, which focuses purely on political and economic indicators, democratic credentials -- or lack of -- have been a key driver in determining the relative performance of frontier market bonds so far this year.

Okay, that conclusion is not in-of-itself especially surprising. But what's interesting is that Exotix's model is timely, covering the period between 31 December and 24 February, and incorporates the whole universe of sovereign issuers in frontier markets. What's more, Exotix use the model as a springboard to highlight the divergence between their own investment recommendations and the index's findings.

Here's their conclusion:

The full document is attached here. Exotix said:

In responding to the direct action of protestors, investors (indirectly) may never before have attached so much weight to democratic credentials, and we suspect there have been few such moments in history when a small number of institutional characteristics can explain so much variation in bond prices. Of course, they cannot explain everything; numerous country-specific factors (and plain old volatility) are not captured: for example the model could not be expected to explain the recent rallies in Ecuador or Serbia.

Here are some takeaways:

• Some 29 per cent of cross-country differences in frontier bond prices since the start of the year is down to the fact that democracy, economic rigidities, labour market participation and inflation in a given economy are now key investor concerns.

• The model correctly predicts the 3 per cent, or greater, jump in bond yields in Egypt, Jordan, Tunisia, Morocco, Iraq and Saudi Arabia this year.

• Some sovereigns with relatively strong democracies have underperformed in 2011, namely Argentina, Costa Rica and Panama, according to the model.

• Conversely, the model identifies other sovereigns with relatively weak democracies as having overperformed so far in 2011. Within MENA, these include Kuwait and Dubai, and outside the region, Kazakhstan, Venezuela, Vietnam, Georgia and Ecuador.

• Exotix conclude that investors should hold Egyptian sovereign debt, since prices are currently 11 per cent below levels seen at the end of last year, while economic and political reform is gathering pace. As FT Tilt has reported, although the government faces a tight repayment schedule and higher borrowing costs, no real solvency or liquidity risks are imminent thanks to strong domestic liquidity. (And remember, before the violence raged, the finance ministry was even considering a 100-year bond in October, hot on the heels of Mexico.)

• Tunisia's short-term economic and political risks are, in many respects, similar to Egypt and according to the model, its sovereign debt is undervalued.

But here a couple of monsters in the closet:

• Although there are many frontier-market sovereigns in the international capital markets, bond markets can herald false dawns since sovereign yield curves are under-developed and typically illiquid. For these reasons, market technicals, rather than economic and political fundamentals, often drive the price performance of a given bond. For example, one might expect Bahraini or Jordanian sovereign notes to widen more given the regional shift away from autocracy. However, bonds from such sovereigns are often in the hands of domestic banks -- seeking an outlet for excess dollar liquidity -- and buy-and-hold real money EM investors in the US and UK. Given the composition of the investor base then, frontier bond markets are typically illiquid, which makes price moves difficult to predict and analyse.

• Perversely, political risks might boost sovereign creditworthiness in the sense that commodity prices shoot up during bouts of instability in commodity-rich nations, as investors price in supply disruption risks. These developments often create fiscal windfalls in such frontier economies. In sum, there is often no direct correlation between political risk and a sovereign bond market slump.

• Finally, political risk is often seen as a low- to medium-probability, high-cost event. And the compensation investors demand for holding assets in potentially vulnerable economies falls during periods of ample liquidity. So when the Fed liquidity tap dries up, political risk fears in frontier economies could rock bond markets more than you expect.