We believe countries should be objectively assessed in terms of their capacity to repay debt – in terms of both income (GDP) and accumulated wealth – rather than simply being lumped into ‘developing’ or ‘emerging market’ buckets. But despite being historical and outmoded, these buckets are still used by many investors to understand wealth, which can lead to considerable mispricing of risk.
Net Foreign Asset (NFA) model
We attempt to take an objective view using the Net Foreign Asset (NFA) model. The model assesses countries in terms of their creditor or debtor status rather than as developed and emerging markets, resulting in a perspective that can challenge preconceived views.
It then gives a risk rating to countries according to their dependency on foreign capital and helps us work out which countries are potentially most vulnerable to financial flows. This aids in the analysis of where the reward for investing justifies the risk. Avoiding bad investments can be as valuable to outperformance as identifying the best performers in fixed-income markets.
What does a weak NFA position mean?
Put simplistically, the NFA position of a country is determined by the total value of assets owned abroad minus the value of the domestic assets owned by foreigners – it is designed to reflect the level of indebtedness of that country.
Countries with a weak NFA position and a high level of indebtedness are the most susceptible to the withdrawal of foreign capital, which can lead to a shortage or higher cost of liquidity, currency depreciation, and higher interest rates.
Countries experiencing these conditions often make bad credit investments from both a corporate and sovereign perspective. Predicting the events that trigger crises is difficult, so identifying and avoiding countries most vulnerable to risk can be valuable from an investment perspective, particularly when compensation for risk is limited.
Iceland’s vulnerability identified
Since the global financial crisis, the NFA model has identified some of the most acute national financial risks and identified countries that have been vulnerable to ratings degradation and economic hardship – Iceland is a good example of this.
Prior to 2007, the country had less than 50% debt to GDP at a sovereign level, while the financial system had geared itself to foreign capital. The focus on growth and debt-to-GDP led to the sovereign rating appreciating as foreign liabilities grew.
As global liquidity contracted, banks were no longer able to finance themselves leading to bailouts, a collapsing currency and a weakened domestic economy which saw the sovereign rating go into freefall, impacting investor returns.
Declining NFA in Iceland identified a vulnerability of the entire economy
The US Federal Reserve’s tightening of quantitative easing in 2013 led to taper tantrums across the world causing sharp outflows of foreign capital and significant underperformance in countries vulnerable to the withdrawal of liquidity.
This led to the depreciation of many currencies particularly in emerging markets as well as greater caution with regard to fundamental risks from a credit perspective.
Qatar and Brazil compared
A comparison of Qatar with Brazil from the same year also demonstrates the benefits of the NFA model. In 2013, Qatar had a far superior NFA position to Brazil and a rating of Aa2 (six notches above Brazil), yet the markets were pricing risks associated with these credits equally.
However, by the time the taper tantrum hit, Brazil was seeing capital outflows, currency depreciation (and ultimately the loss of its investment grade rating), as well as wider credit spreads, while Qatar remained comparatively unaffected.
The NFA model can be used alongside the relative value model to assess the extent to which downside risks are priced in, or where strength is not appreciated, precisely the inputs which helped us to see that Qatar was a value opportunity while Brazil was arguably overvalued at that time.
Screening out countries
The model can be used to screen out countries which fall foul of our metrics as well as setting an objective base to evaluate risk. This leads to a portfolio solution which has a focus on country risk, not one driven by the size of issuance, creating a unique geographical approach and diversification versus mainstream strategies.
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Links to fund pages
- New Capital Global Value Credit Fund
- New Capital Wealthy Nations Bond Fund
- New Capital Asia Value Credit Fund
- New Capital Euro Value Credit Fund
- Institutional strategies
Learn more about the advantages of our wealthy nations approach read our whitepaper Giving Credit to the Creditors.