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Cautious investors are looking toward the east
By Eytan Avriel

What kind of investment instruments are the big, private investors (who consider themselves sophisticated) making these days? Certainly not shares.

The experts, the analysts and everyone in the business world (except those whose livelihood comes from selling shares or managing share-oriented investment funds) all agree that share prices are too high. After gains of tens of percentage points on every stock market around the world, the only dispute is over which bourses have already reached bubble status, and which are accurately reflecting their economic value. There is no talk of double-digit opportunities, even among those who do recommend shares.
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There is actually a growing movement of economists and analysts who opine that the era of shares has ended. The basic argument is that if the global economy and the Western economy are growing very slowly, stock-market yields will stand at a few percentage points at best (in the good years before the global economic crisis, stock markets were yielding 7%-9% a year). Since bonds offer low yields but are less volatile and take precedence when a company is dissolved, the stock market essentially has nothing to offer.

Bank deposits are nothing to get excited about either. Even though many economists predicted a year ago that interest rates had to rise in order for governments to continue raising money, short-term interest rates are still very low - such that bank deposits are barely able to maintain their value. It will likely be many months before interest rates rise significantly, especially in light of the U.S. Federal Reserve's promise not to raise interest "for a long time."

So what's left? Mainly bonds. Therefore smart market players are scouring the world for bonds with reasonable yields and equally reasonable risks. Large, stable companies, mainly foreign ones, meet these criteria, offering bonds bearing interest 2%-3% above the government interest, meaning 5%-6%.

Investors who generally shy away from risk, but are still afraid of interest hikes, are focusing on one particular type of bond - those with floating interest. The yield on these bonds is linked to the LIBOR rate, meaning their value will not decline once interest rates start climbing. Still, this type of bond has its risks - namely that the issuing company will collapse. Investors in corporate bonds can lose money even if a company does not become insolvent, because the market is sensitive to any change in a company's financial situation. An announcement or financial statement indicating financial weakness can push bond prices down, similar to the way share prices react.

Another type of bond investment attracting institutional investors and smart investors is government bonds - particularly those of developing countries. In the past few weeks, for example, there have been several big bond issues in countries such as the Philippines, South Korea and Singapore - with even China considering a bond issue - and there is brisk demand for all of them.

There are three reasons why such bonds are now so popular. First, despite the global economic crisis, the economies of developing nations are still considered less stable than those of Western countries, so the yields on their bonds are higher than in the West. Second, when an investor buys foreign government bonds, he is also investing in foreign currency. In the past this was quite risky, but today - when the world is convinced that the dollar will continue to weaken while currencies of developing countries gain strength - the currency diversity is actually a bonus. Third, many investors are not interested in U.S. government bonds, as 3% interest for 10 years is considered too low. Higher interest rates, and the inflation that will eventually return, will hurt the bonds' value.

In Israel there is healthy demand from foreign investors for shekel-oriented bonds, as the shekel is appreciating against foreign currencies. Foreign investor demand in Brazil for government bonds (and other assets) was so great that last week the government decided to levy a 2% tax on foreign investors who buy stocks or bonds, in an attempt to halt the strengthening of the Brazilian currency. This is an extraordinary move for a developing country; until now developing nations have always bent over backward to attract foreign investors. The tax shows how much the recent crisis has changed the balance of power between the West and developing countries.

Based on the above logic, the government bonds of developing countries are becoming a real hit. Israel, for example, has no difficulty issuing bonds abroad in any currency it chooses. A recent $1 billion bond issue by the Philippine government - for 20-year and longer bonds with dollar-yields of about 6.4% - attracted $5 billion in orders. Similar U.S. government bonds bear 4.3% interest.

Worldwide orders for government bonds of developing countries now total about $900 million a week, up from $280 million a week in the third quarter of this year and $80 million a week in the second quarter. What about the risks? The collapse of a country's economy, resulting in the non-payment in full of government bonds is not impossible, but is extremely rare. Such examples from the past decade include Russia and Argentina. Some Eastern European countries are considered risky today, but drastic scenarios are unlikely in countries whose economies are growing rapidly and which have steady infusions from foreign investors.

There are even ways of assessing the risks: the accepted and most accurate gauge used by professional investors is the cost of the credit default swap on each bond. The CDS is a financial insurance contract, and the unit measure is the annual cost, in dollars, for full coverage on a $10,000 face value five-year bond. Last month, for example, the CDS was $153 on Philippine bonds, $99 on Israeli bonds and $1,017 on Argentinean bonds. The CDS on American bonds is in euros. How much? 21 euros for every $10,000 in bonds, making them a suitable instrument for cautious investors. The yields on government bonds from developing countries are not as high as before the crisis, but as the global economy recovers their yields will rise, too.
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