Iceland and an “I wish I was wrong” moment

An Analysis of the Icelandic Bond Market: A Change of View (Excerpt)
16 July 2001
by Joseph L. Ladrido
Hulda Pjetursdottir

EXECUTIVE SUMMARY

The Icelandic bond market has drawn considerable interest in the last 12 months as a result of a changing macroeconomic and regulatory environment. The question, which we seek to provide a guide to an answer is – have Icelandic bonds, peaked and are they due for a correction?

The underlying fundamentals of the Icelandic economy have provided the basis for this investment interest. GDP growth is entering into its fifth year of at least 3% annual expansion from 1996. This growth coincides with significant and radical changes in the Icelandic financial market in the drive to conform to financial market regulations set forth by the European Union.

Until the 1990s, Iceland has had a history of economic turbulence. Currency devaluations and high inflation were the norm. This turbulence has died down considerably as a result of the deregulation of Iceland’s financial sector in 1990.

The Icelandic bond market has undergone dramatic changes in the last 2 years as a result of regulatory changes. In April 1999, new bank liquidity requirements as enacted by law left out the bond holdings of banks as a component of measures of liquidity. This forced a sell-off of these bond holdings forcing yields down and depressing bond prices. These requirements were, however, relaxed at the beginning of last year. Government bonds were included in liquidity requirement calculations. This, however, coincided with a shift to international equities by investors and a significant increase in new bond issues. These 2 factors combined to weaken interest in Icelandic bonds.

The fall of 2000 saw increasing indications of an overheating economy. Inflation was expected to pick up. This is significant in the context of Icelandic government bonds mostly being indexed to inflation. This being the case, they become more attractive as inflation rises.

This continues to be the consensus investment argument. An inflationary environment is good for index-linked Icelandic bonds. The key risk would be the impact of rising inflation on the currency.

This paper looks at the market outlook in the context of the environment presented above. It is written with a view towards making a case to entice or discourage institutional investors in the United States to/from invest/ing in Icelandic bonds.

Given the academic framework of the independent study, we will also present an overview of bonds with a discussion of presenting its key features and characteristics.

We will also delve on the risks of bond investing. These will serve as the foundation upon which we will build our analysis of the Icelandic bond markets.

INVESTMENT THESIS

We believe that Icelandic bonds have become unattractive to investors particularly in the United States. This negative view is based on 2 major points:

• Continued expectation of krona depreciation to increase currency exchange risk.
• Rising inflation expectations will temper bond prices.

Why invest in international bonds?
Domestic bond investment is predicated on getting superior returns from a combination of income from coupon payments and the expectation of bond price appreciation. On top of this, international bond investment incorporates currency returns from investing in foreign pay bonds or bonds denominated in a currency other than that of the investor’s home currency. Another key attraction for investing in international bonds is the diversification benefit of investing in an asset which has either a negative or minimal correlation to other investment assets in an investment portfolio.

Krona depreciation to hurt currency returns
The depreciation of the krona will impact negatively the currency returns of American institutional investors. We believe that the krona will continue to be under pressure due to fundamental factors suggesting further depreciation. The primary driver of this is the continued widening of the current account deficit. Rising inflation will also serve to widen the relative inflation gap between Iceland and the United States putting further pressure on the krona to depreciate.

Rising inflation = Rising interest rates = Falling bond prices
Rising inflation expectations (see chart on next page) will eventually force the Central Bank to increase interest rates. The Central Bank has set a target of bringing inflation down to 2.5% by the end of 2003. Current inflation expectations are for inflation to surge from the current 3.5% to 6% in the short to medium term(1). If inflation rates remain at this level by the end of 2002, the Central Bank could initiate radical measures to control inflation through interest rate hikes. This will push bond prices down substantially. This scenario is not totally unforeseeable due to some structural weakening as can be gleaned from Iceland’s national income account numbers.

Current account deficit at a dangerous 11.1% of GDP
The current account deficit has grown by a consolidated annual growth rate (CAGR) of 65% over the last 4 years to a current amount of $877m. This is a staggering 11.1% of GDP. The deficit has been driven mainly by a deterioration in the balance of merchandise trade and services. The trade deficit has gone from a $45m surplus in 1996 to a $626m deficit in 2000. This has happened as import growth outpaced export growth from 1995 to 2000. Imports grew at a CAGR of 10% over that period while exports grew at only 3%. While expectations are that the deficit may not grow as fast as it did before, it will take some time before the deficit itself is reduced, much more reversed.

No diversification benefit
The diversification benefits of investing in overseas bond markets has been well publicized. It has also been documented however that the reduction in portfolio volatility of a combined US and foreign portfolio is relatively small (2). Thus, the prime motivation for foreign pay bond investment should be the expectation of superior returns to domestic US bonds. This is not the current case with Icelandic bonds.

Contrarian view
We believe that the impact of the currency depreciation will outweigh the potential attraction of Iceland’s inflation-indexed bonds. Bond prices, as with most asset prices, tend to overshoot fair values in a deteriorating investment environment and will exceed the benefit of nominal increase in coupon rates.

The view, which we have just presented, is a departure from the heretofore, positive outlook for investing in the Icelandic bond market. As such, we believe that it is not to late to reduce, if not completely sell off, holdings of Icelandic bonds.

(1) National Economic Institute, Economic Developments in 2001 and Outlook for 2002, June, 2001.
(2) Michael R. Rosenberg, International Fixed Income Investing Theory and Practice, Handbook of Fixed Income Securities (6th edition), McGraw-Hill, 2000.

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