Fixed Income Investing Amidst a Commodities Boom | Barita Insights | June 28, 2021

Commodities, particularly ones linked to capital expenditure such as iron and copper tend to perform well in periods of high growth and infrastructure development. Goldman Sachs projects that copper prices will reach an average of US$11,875 per tonne by end 2021, up from as low as US$4775 in June 2020. The current price runs in commodities, if proven to be long term as in the case of a continued upcycle should therefore be an important variable that we factor into our investment decisions. A particular question that is to be asked is in relation to fixed income, particularly sovereign bonds, and that is, who would be the winners from a continued commodity surge and what are the actual channels through which they win?

The most obvious conclusion is that the most likely winners are those commodity exporting nations. Numerous research such as Restrepo-Echavarria et al (2016) and McGregor (2019) will cite that the bond spread of commodity exporting nations tend to be highly negatively correlated to commodity prices. To understand the nuances in this we must understand that for credit analysis, major components that drive both ratings and spreads are the current levels of debt in the country, the level of government revenues and also the projected growth of the local economy. We can then appreciate how surging commodity prices impact these factors for developing countries and by extension the quality of their debt.

Rising commodity prices implies improving terms of trade (the ratio of the price of imports to the price of exports) which facilitates an improvement in what is known as the trade balance. This is the value of exported goods minus the value of imported goods. The Trade balance is a component of the overall Current account balance which encompasses trades in goods, services, transfer payment etc. Rating agencies often use the trend in the current account balance as one of the measures to judge a sovereign’s credit quality. A trade/current account deficit must be funded from somewhere. When people in a country are buying more from abroad than they’re selling, this leads to a build up of foreign claims on local assets which primarily shows through rising external or public debt.

While in theory an improving term of trade should point to reduced debt, there are several caveats to consider. Firstly, the long-term impact on debt might depend on government. Government expenditure is often sticky upwards, and so spending might increase with revenues in a boom and not decline in a downturn leading to greater long-run debt. Hence the quality of Government resource management is a key factor in determining which sovereigns benefit the most from booms. Secondly, the extent of the impact prices will have on the current account will depend on the ownership structure of the sector. For example, a study done by Medina, Monro & Soto (2007) decomposed the variance of the current account for Chile and New Zealand and noted that commodity price increases had a smaller impact on the current account for Chile, with one reason being the higher degree of foreign ownership which offset trade surpluses with investment income deficits due to copper profits accruing to non-residents.

In the case of non commodity exporting countries, high commodity prices, particular for essentials such as crude, has a deleterious impact on the current account and debt sustainability. It also has the possible effect of raising domestic inflation (which places upward pressure on bond yields and domestic currency depreciation). It is expected that the sovereign credit of these net importer would suffer the most from rising prices. In the context of the Latin America and The Caribbean, such countries include Uruguay, Chile, Peru and most caribbean island nations outside of Trinidad which are dependent net oil importers including, Jamaica, which means that even JAMAN bonds would be negatively impacted. On the flip side, Net exporters such as Colombia, Mexico and Ecuador stand to benefit from rising crude prices and might therefore reflect opportunities to look out for.

Lastly terms of trade improvements might impact the quality of exporting nations’ credit by its impact on Government revenue and growth. The windfall through higher revenue from the exporting sector increases the ability of government to pay down debt and/or invest in growth inducing infrastructure further boosting credit capacity. In the context of a floating exchange rate this point is further improved as more exports, all things else constant, will appreciate the domestic currency, reducing the real cost of foreign denominated debt. The potential caveats to this include the prior point of possible poor resource management by government but also the phenomena of Dutch disease which might impact other sectors of the domestic economy. ‘Dutch disease refers to the expansion of some sectors of the economy (in this case the commodity export sector due to higher prices and profits pulling in labor) and a decline in other sectors as labor and investment is pulled into the commodity sector. The sectoral impact of commodity prices also presents investment opportunities in the Corporate bond sphere with corporations operating in the commodity spaces enjoying higher margins and profitability. Credit rating agencies incorporate sector outlooks in their credit analysis, and it is common to see credit downgrades/upgrades depending on downward/upward trending commodity prices. We have for example been seeing more US exploration and production companies issue lower yielding debt as oil prices recover from 2020 lows.

In conclusion rising commodity prices can greatly impact the quality of debt issued by commodity producing nations and corporations and as such if the current trend in commodity prices (particularly copper and capex commodities) continues, these entities will likely benefit. However, an investor would be better able to extract maximum benefits from monitoring countries that have a history of proper management frameworks in place for export earnings and also countries where the benefits from price increases more directly accrue to government and to the actual owners of external debt locally.