Gambling on Third World debt

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The Independent Online
Investors who positively enjoy a calculated gamble are being offered, later this month, a stake in Sovereign Debt Trust, a new Dublin-based investment trust sponsored by brokers Greig Middleton, run by Baring Asset Management and part-financed by ING Bank. The new trust will invest in bonds and loan stocks issued by Third World countries, especially in Latin America, Central and Eastern Europe.

Its sponsors claim that it will be less risky than trusts investing in the shares of companies listed in emerging markets, on the less than wholly reassuring grounds that a financial collapse would certainly knock bond prices, but there would always be some residual value, while a collapse would also knock share prices and could wipe out many companies altogether.

Investors willing to investfor its 10-year life may face some sleepless nights if there are too many re-runs of the crisis that struck the Mexican economy last February and rippled round the emerging economies, but if the process of integrating them into an expanding low-inflation world economy suffers nothing worse than the occasional panic, then the returns could be far greater than in developed economies.

The trust will be able to borrow up to 20 per cent in addition to the capital that investors subscribe, in order to gear up its investment capacity. More than half the money will always be invested in Brady bonds, the name given to debt stock issued by 15 developing-country governments (mainly in Latin America) to refinance bank loans on which they had defaulted in the Eighties. The bonds were issued as part of a package negotiated with individual debtor countries. Part of their debt was excused in return for accepting tough new rules to promote the private sector of their economies, and agreeing to run their economies responsibly. More than $140bn (pounds 90bn) worth of bonds are currently traded and the market is very liquid.

So far none has defaulted again, but Brady bonds issued by countries like Brazil, Mexico, Argentina, Venezuela, Poland and Nigeria are only rated B or BB by international credit agencies like Standard & Poor's. In other words they are below investment grade. They fell by as much as 20 per cent early in 1994 after the US signalled an upturn in its interest rates, and fell a further 20 per cent in the first quarter of 1995 after the collapse of the Mexican peso.

Nigeria's Brady bonds fell by 10 per cent last week after the government defied world opinion by executing Ken Saro-Wiwa. But most Brady bonds are denominated in US dollars, carry a good rate of interest linked to the London market rate for dollars, or were issued at a substantial discount, or both, and some are backed by an element of collateral in the form of US Treasury bonds held by the emerging governments.

When their economies prosper, and when US interest rates are falling, the positive impact on Brady bonds is magnified. Over the last five years total returns including capital and income have been running around 100 per cent, compared with a 60 per cent cumulative return on US Treasury bonds. The average rate of return has been around 14 per cent plus a capital gain of 4 to 5 per cent, producing overall returns of up to 18 per cent a year, compared with around 6 per cent on Treasury bonds.

The managers can also put up to 15 per cent of the fund in other hard- currency bonds, including Eurobonds and US bonds issued by emerging country governments, and up to 5 per cent in bonds that are in default but can still be bought and sold, often at big discounts to their nominal value. Many Russian loans are in default, but they represent excellent value if the Russian economy comes good, according to Michael Mabbutt at BAM, who will be in charge of the fund. A maximum of 15 per cent can also be invested in debt denominated in local currencies, where nominal yields can be enormous, but so can the rate at which the currency depreciates against the dollar.

The portfolio will be spread across 15 to 20 countries and 30-odd different stocks, and will be traded quite actively. The initial expenses will depend on the amount raised, but if the target of pounds 50m is reached they should not be more than 3 to 3.5 per cent, including a 1.5 per cent commission for financial advisers who introduce investors. The initial charge to investors will be not more than 3 per cent, and the annual management charge 0.95 per cent.

The trust is expected to appeal to institutions and to high net worth individuals in the US, UK, Europe and the Middle East. Being based in Dublin the trust will pay no corporation tax or gains tax, and it is expected to pay an annual dividend of 11.5 per cent, payable quarterly, and yield 14 per cent a year if held to redemption. If the market is depressed when the trust comes to the end of its planned life in 2005 it will probably be converted into a longer-term asset, according to David Thomas at Greig Middleton.

Shareholders can take dividends in cash, elect for new shares, or have their dividends reinvested in existing shares, a device that would allow the managers to buy up shares overhanging the market and reduce any discount to asset value that might develop. The minimum subscription will be $10,000 or pounds 6,000, but as a European company the trust qualifies as a single company Pep and investors can put a full pounds 6,000 into a Pep package.

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