Two Standouts Outperform During Global Debt Route
India and Indonesia's debt outperformed during the recent extreme volatility in the global capital markets. According to data compiled by Bloomberg, India and Indonesia's debt lost 0.4% and 1.5% for dollar-based investors in Q3, much less than most other debt offerings. Other EM debt and currencies seem more sensitive to U.S. interest rates and lost significant ground as the Federal Reserve in the United States started raising short-term borrowing rates. The large spread that India and Indonesia attract relative to U.S. Treasury yields was an attractive component to their bond offerings and attracted investors as global bond markets sold off.
What is a Debt Offering?
When a country issues debt, it raises capital to allow the government to operate. Debt is a financial obligation with the promise that the country will pay the lender back in the future. Debt issued from governments include bills, notes, and bonds. When a government borrows capital from a bank, it is called a loan. It is called a debt issue when it borrows money from investors in the capital markets. Debt issues can be as short as a day and as long as 30 years. Most of the debt sold by governments is issued in an auction format.
What is the Cost of Debt?
The cost of borrowing capital is the interest rate paid to the lender. For example, if a government 10-year bond has an interest rate of 5%, they would pay the lender (the bond buyer) an annual interest rate of 5%. If you purchase $100 of bonds, you will receive $5 per year for ten years. The cost of debt is based on several factors. While not always the case, the longer the loan (debt issuance), the higher the interest rate.
Additionally, the better the borrower's credit, the lower the interest rate. For example, the United States is more likely to be able to pay a loan back than an emerging country like India. Because the market feels this is likely, the borrowing rate for the United States is about 4% less than the borrowing rate for India. In some cases, emerging countries have a lower interest rate than the United States. For example, the borrowing rates for China and Thailand are less than the borrowing rates for the United States for ten-year issuance.
How is Debt Traded?
The debt market is traded just like other capital market. Once a government issues debt, it will sell it directly to market makers and the public. Government debt can also be traded in the secondary market. The interest rate on the debt will also change as the market changes. A government might issue a ten-year note at 5%, and during the life of the issuance, it might see interest rates as high as 6% or as low as 4%. Debt can be traded in someone's home currency or denominated in another currency.
What is the Importance of the Currency Market on Debt?
The impact of currency fluctuations on debt can be significant. The return profile offered by Bloomberg is in constant currency fluctuations anchored in U.S. dollars. India's debt return of a decline of 0.4% during the period is down more than 15% in euro terms as the EUR/USD declined by 15% year to date. Most sovereign countries issue their debt in their home currency.
Several debts are issued in dollar terms. For example, approximately 53% of the debt is issued in U.S. dollar terms. Indian Rupee-denominated debt makes up slightly more than 31% of the total external debt issued. The question “what is forex trading related to debt?” follows the idea that you need to comprehend how the forex market will move to understand your base returns.
How do Foreign Exchange Reserves Play a Role in Debt Issuance?
When a government issues debt in another country's currency, you want to ensure that the issuer has enough foreign exchange reserves to handle the payouts. For example, India has foreign exchange reserves close to 100%, and they were as high as 138% in 2008 and as low as 68% in 2014. A country can avoid an unfavorable rate if it has adequate reserves but will be penalized if it does not show adequate forex reserves.
Why Do Traders Buy and Sell Debt?
The sovereign debt markets are generally liquid and provide significant returns for individuals and companies looking for fixed returns. If you purchase a government bond in your home currency and are confident that the government will pay the interest, then the most you will lose is the interest on your capital. However, there is a way to gain more. If you purchase debt and the price rises (the interest rate goes down), you can earn money on your debt. If the gain on your debt is more than the gain you would receive by holding the insurance, one might consider taking a profit.
The Bottom Line
The upshot is that debt in India and Indonesia outperformed the debt of other EM counties during Q3. Debt the global selloff, the higher premiums paid by India and Indonesia attracted investors as interest rates were rising. With India and Indonesia showing premiums of nearly 400% over the 10-year U.S. Treasury note, the high level of reserves makes investors believe that 8% returns tied to the U.S dollar are attractive. Premiums usually fluctuate based on the credit of the country. For example, traders likely consider India's credit worse than the U.S. credit.
The downside is that the price could move lower, and you then need to hold your bond for ten years to avoid a loss. Debt can be issued in local currencies or against some major currencies like the U.S. dollar and the euro. Debt is traded in the primary market directly to investors or market makers and through the secondary market, where the price fluctuates along with local and global interest rates.