By Charles Ross, Contributor 
ROSS
IN OUR last article we looked at the two principal risks associated with investing in bonds - default risk and price risk - and the role that rating agencies played in helping investors assess the relative risks of holding the bonds of one issuer versus another.
The ratings assigned to the countries or companies issuing bonds are useful guides to the relative risk of default associated with those particular entities so that the bonds issued by a country with a B rating carry a greater default risk than those issued by a country with a BB or BBB rating.
DEFAULT RISK:
SOCIO-ECONOMIC FACTORS
However, the economic and political circumstances of a country can change over time and the ratings do not always keep up with these changes.
Argentina, for example, was rated BB- up to a few months before its default. This is why investors in bonds do need to keep an eye on the economic and political developments in the countries whose bonds they have purchased, both before and after they make the investment.
This latter point is particularly important since the decision by a country to default on its bonds is primarily a political decision and not one that is motivated by purely economic reasons. This point is illustrated by a comparison of the fiscal positions of Argentina, Brazil and Jamaica.
Of the three countries, Argentina had the lowest Debt-to-GDP ratio and also had the lowest primary surplus target of about two per cent of Gross Domestic Product (GDP). (The primary surplus is the difference between expenditure and revenue, excluding the interest cost of the country's debt).
Brazil is next with a Debt-to-GDP ratio of about 60 per cent and a primary surplus target of 3.75 per cent of GDP. Jamaica tops the table with a Debt-to-GDP ratio of 150 per cent and a primary surplus target of 10 -12 per cent of GDP.
However, it was Argentina that defaulted and, although Brazil is very much on target with its fiscal programme, fears have arisen that a change in political leadership may weaken its commitment to the current fiscal effort and lead to a default on its debt. Jamaica - which has the weakest position on paper - is also facing a possible change of government, but there is virtually no fear in the market of an imminent or even distant possibility of default.
This is a reflection of the market's confidence in the political commitment of the country's leaders to honouring the country's debt obligations.
PRICE RISK & THE IMPACT OF MARKET FACTORS
While ratings can, with the provisos mentioned above, give a fairly good guide to default risk, they are not as useful when it comes to price risk. This is because market factors have a much greater impact on the prices at which particular bonds trade, than do the economic factors that affect creditworthiness.
A comparison of the bonds issued by Jamaica and Venezuela illustrates this point. Both countries are rated B and Venezuela is a large exporter of oil with a current account surplus, large international reserves and a relatively small foreign debt.
Despite these factors, Venezuelan bonds trade at a steep discount - offering much higher yields than Jamaican bonds and fluctuate significantly in price. On the other hand, Jamaican bonds trade at a premium, do not fluctuate as much in price and have tended to appreciate in value over time.
There are two major reasons for the differences in the performance of bonds issued by the two countries: In Venezuela, there is political uncertainty because of the left-wing Chavez regime that is in power; in Jamaica, a large portion of this country's bonds are held by Jamaicans who tend not to trade them frequently.
The steady demand from Jamaicans for their country's bonds is probably the principal factor behind the steady appreciation in the prices of the bonds.
PERFORMANCE HISTORY
- THE BEST RISK GUIDE
The best guide to the price risk associated with a particular bond is the historical movement in the price of the bonds issued by that country. The extent to which bond prices fluctuate is called the volatility of the price and although there is no guarantee that the historical patterns will always hold true, they can be a very useful guide as to what to expect in the future. A good investment broker should be able to provide this information.
For the small to medium sized investor who is new to bonds, it is perhaps safest to start by investing in the bonds issued by the country in which you live or with which you are very familiar.
That country would be Jamaica for most of us who live here. We get the news on the economy and on the government's policies on a daily basis and, even if we don't interact directly with the policymakers themselves, many of us have access to someone who does.
This keeps us at the forefront of the knowledge curve and, in any event, Jamaica's global bonds have proven to be very attractive investments thus far. In our next article we will look at how global bonds are traded and some of the issues affecting their liquidity.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
