Conquering the Steppes with Genghis Bonds

A frontier market, Mongolia, has unleashed its Genghis Bonds denominated in US dollars, that will help them conquer their steppes. Yet, the question is whether investors will be able to conquer their steppes too.

12th century Genghis Khan - Mongolia's most famous export

Mongolia transitioned from a one-party communist political system into a democratic system in the 1990s. The Economic Political Stability Index 2013 and Economic Freedom Index 2013 highlight that Mongolia, ranking 75^th out of 177 countries, fares above average in the world. Corruption is also down with Mongolia ranking 94^th out of 174 countries on the 2012 Corruption Perception Index. Yet there have been some political problems with the government in 2012 suspending South Gobi Sands mining licenses and then asking to renegotiate the Oyu Tolgoi investment agreement. Economically, Mongolia, bordering two monoliths - Russia and China, is the most sparsely populated country in the world with just 2.8 million people within a country boasting more than 6,000 known mineral deposits that could enable Mongolia to become a major determinant in global gold, copper, zinc, coal, oil, uranium and molybdenum markets. Since the 1990s, Mongolia’s economy has shifted from largely agriculture-driven to a reliance on the minerals industry. Mongolia also has one of the world’s fastest growing economies with real GDP growth averaging 13.5% annually over the next five years, comparing favourably with China’s at 8% and India’s at 7.6%. Yet due to an undiversified economy and inflationary monetary and fiscal policy, Moody’s have given Mongolia a speculative grade B1 credit rating. The mining boom has increased foreign direct investment into Mongolia from US$100 million in 2003 to US$6.1 billion in 2012 with the majority of those flows derived from China, Canada and the Netherlands. In addition, Mongolia possesses competitively priced raw materials, low operating costs for foreign companies, a low corporate tax rate, favourable tax credits and cheap labour culminating in a favourable investment environment. In fact, according to the World Bank’s 2012 Ease of Doing Business Rankings, Mongolia is ranked very similar to Italy and higher than China and Russia.

In November 2012, Mongolia sold US$1.5 billion in debt in its first government bond offering, equal to nearly one-fifth of its total economy. The US$500 million five-year bond yield was around 4.125% and the US$1 billion ten-year bond yield was around 5.125%. As a comparison, Spain, the Eurozone’s fourth largest economy had its ten-year bond yield at 5.3%. The November offering was ten times oversubscribed with US$15 billion in bids compared with the size of Mongolia’s total economy valued around US$10 billion. The bond issues by the Mongolian government aimed to raise finance for infrastructure to develop its booming mining industry. International investors seem desperate for incrementally greater yields, which has been the driver behind Mongolia’s low bond yields. The difficult search for high yield assets in the current economic climate has allowed Mongolia to obtain yields that are likely half of what they would have to offer investors under normal credit conditions. In addition, the fact that Mongolian debt is relatively rare also added to investor demand as investors sought to diversify their portfolios. In fact, relativity is another of the drivers behind Mongolia’s low yields – Genghis bonds look great compared to 2.5% for a 10-year Mexican bond and 1.6% for the US 10-year Treasury Bond.

Despite the risks, Genghis Bonds are proving a hit

Yet some investors caution buying Genghis Bonds at such low yields, arguing that such yields do not capture the risks inherent in a frontier economy with a history of political instability. Mongolia has asked for emergency loans from the International Monetary Fund five times in the past 22 years. Genghis Bond yields stumbled US$7 in December due to political instability when the fragile coalition government ordered cabinet ministers from the Democratic Party to leave, but they have since crept up again. Furthermore, Mongolia’s economy are currently having to deal with weaker global commodity prices as gold and energy prices in particular have dropped sharply. The problems creditors are having with Belize’s default over a US$544 million bond and with debt from Saint Kitts and Nevis highlight the dangers with frontier debt. Investors also have to beware of the volatile legal and regulatory environment in Mongolia as they draft new foreign investment rules pertinent to the mining sector.

I guess what has priced Genghis bond yields so close to Spanish bond yields is that investors are asking whether they would prefer the financial gains and political risk of Mongolia on the one hand or the risk of euro contagion of Spain on the other hand. Given the larger risks for a Spanish meltdown, it is no wonder that investors believe that Mongolia could just be able to service their debts better than Spain. Other investors worry that this is a bond bubble that will burst when the US Federal Reserve begins raising interest rates again – yet for now we are not close to the bursting point and Genghis bonds, denominated in USD, could be boosted if we are yet faced with further eurozone deterioration.