Monday, May 23, 2005

Quest for yield: Peso bonds

With real yields on U.S. bills and bonds perilously close to cero, investors are leaving no stone unturned in the search for decent returns.

This is leading many to markets they would’ve never heard of, let alone invested in, not long ago. For example, consider the case of Mexican government bonds issued in pesos. Believe it or not, they’re a novelty: before 2000, the only paper issued matured in one year or less. Now, you can even get 20 year bonds.

If that sounds like your idea of playing Russian roulette, there are an awful lot of candidates willing to give it a shot for yields that currently average a grand total of …..10% (check them out in Banco de México’s site). Currently, foreigners own around 20% of the total amount outstanding; a year ago, that proportion stood at 6%, even though the spread between U.S. and Mexican Bonds hasn’t risen much.

How crazy is this bet? It’s hard to tell. Your main enemy is, obviously, exchange rate risk. The yield in dollars of this investment will, basically, amount to your gross yield in pesos minus the peso’s accumulated depreciation against the dollar. So, if you buy for keeps, to earn more than you would if you purchased an equivalent U.S. bond, you need the peso to depreciate less than 5% per year against the dollar.

Forecasting exchange rates is a dangerous game. The peso has floated only since 1995 and it spent the next few years recovering from the Tequila crisis. Yet, over the last five years, it has only fallen on average around 3% a year against the dollar. This despite the lackluster performance of the Mexican economy (low growth, but stable interest rates and inflation). So, if this keeps up, you’d earn between 6% and 7% in dollars, a bit more than you’d get investing in Mexican bonds issued in dollars. However, if you’re a Mexico bull –an admittedly rare species, but apparently gaining in numbers—and believe the peso will stay stable or even gain a bit against the greenback, a 10% yield in pesos looks mighty good.

What do Mexicans think? With an old-school populist leading the race for the 2006 elections, they’re keeping an eye on politics, fastening the hatches for likely turbulence and praying that a divided Congress and a formally independent central bank will hold back the barbarians at the gate.