North Korea Lures Hedge Funds to Bonds With Nuclear Promises

Date: Saturday, January 12, 2008
Author: Patricia Kuo and Lester Pimentel, Bloomberg

North Korea, where one-third of the people suffer from malnourishment, is attracting bond investors speculating that the country will give up its nuclear arsenal in return for U.S. aid.

The communist nation's defaulted bonds rose 36 percent last year on optimism North Korean leader Kim Jong Il would buckle under U.S. pressure and agree to divulge details of his nation's atomic weapons program, according to Exotix Ltd., a London-based brokerage that specializes in distressed securities. The $459 million of zero-coupon debt is up more than 60 percent since Kim's regime tested its first nuclear device in October 2006.

The gains may not be over. North Korea's bonds traded at about 60 percent of face value in the first half of 1998 on bets the country would be absorbed by South Korea, compared with 32 percent now. The U.S. said yesterday that Kim needs to submit a declaration with details of the nuclear weapons by March in exchange for economic aid.

``If North Korea meets the deadline, it would be a great positive spin on the debt,'' said Amir Zada, assistant director in New York at Exotix.

Trading North Korea's bonds, which went into default 32 years ago, averages about $350 million a year, mainly by investors betting on unification with South Korea, ``or at least regime change,'' said Florian Schmidt, head of Asia debt capital markets with ING Bank NV in Singapore, a unit of the biggest Dutch financial services company. About $114 billion of U.S. government securities trade each day, according to data compiled by the Treasury Department.

`Unification Play'

``The debt is the easiest way to get involved in the unification play,'' Zada said. ``It's one of the last historic debt plays out there. Most of the other countries with defaulted debt have had buybacks or received 100 percent debt write-offs.''

North Korea ``faces desperate economic conditions'' caused by shortages of food, fuel and tractors, according to the CIA World Factbook. One-third of North Koreans are malnourished, and many scavenge for ferns, acorns, grass and seaweed to survive, according to the United Nations World Food Program.

North Korea is on a list of countries the U.S. accuses of sponsoring terrorism, limiting economic assistance. Gross domestic product contracted in 2006 for the first time in eight years, shrinking 1.1 percent after expanding 3.8 percent in 2005, according to South Korea's central bank. Its economy is less than three percent the size of South Korea.

Ivory Coast

North Korea's debt trades at about 32 cents on the dollar, up from less than 20 cents in October 2006, according to Exotix. Last year's rally was the second biggest in the world among defaulted bonds. Ivory Coast's 3 percent Brady bonds maturing in 2018 climbed 55 percent in 2007, the firm said.

Dollar-denominated bonds issued by developing countries returned 6.4 percent in 2007, down from 10.6 percent in 2006, according to a Merrill Lynch & Co. index of 189 securities.

``Capitalism will eventually find its way into the country,'' said Winston Wei, founding partner of New York-based Quartersaw Investments LLC, who manages $14 million and started buying North Korea's debt at 23 cents in 2006. ``While the regime has so far defied skeptics and has lasted for more than 50 years, we are beginning to see cracks in the system.''

Investors have been burned before trading North Korea debt. The bonds fell to about 25 percent of face value after unification with the south failed to materialize in 1998 and emerging markets worldwide crashed, according to Exotix.

`Dear Leader'

Kim, known as ``Dear Leader'' among Koreans, has missed two U.S. imposed deadlines to disclose details about the weapons program, most recently on Dec. 31.

``The North Korean regime will eventually break up but it should take a long time,'' said Morten Bugge, chief investment officer at Kolding, Denmark-based hedge fund Global Evolution A/S. ``Don't get your hope up on unification.''

Bugge, who has traded the distressed debt of Cuba, Vietnam, Sudan and Ivory Coast since the mid-1990s, said North Korea's bonds aren't cheap.

``It may need to fall back to about 26 or 28 cents for us to consider buying it again,'' Bugge said. He recommends considering North Korea's non-securitized loans instead.

BNP Paribas SA, France's biggest bank, in 1997 turned about half of North Korea's defaulted commercial bank debt into notes denominated in deutsche marks and Swiss francs, secured by the non-performing loans. Holders of the securities will receive the loans if the notes haven't been repaid or restructured by the time they mature in March 2010.

North Korea owes more than $15 billion, including $3 billion to commercial banks and funds, according to estimates by Exotix.

U.S. Demands

U.S. Assistant Secretary of State Christopher Hill is in Asia to persuade Kim's government to disclose details of its nuclear program after missing the latest deadline. The nation must show ``full transparency,'' Hill told reporters yesterday at South Korea's Incheon International Airport.

The country also missed an April 14 schedule to close its main facility for manufacturing nuclear weapons plutonium because $25 million of its funds at Macau-based Banco Delta Asia SARL were frozen. The U.S. accused the bank of laundering money for the communist state. Bank officials denied the allegations.

Kim pledged in June to implement the disarmament-for-aid accord signed in February with the U.S., South Korea, Russia, China and Japan once the block on its accounts was lifted.

``Its insistence on unfreezing a meager $25 million in the Macau bank as a condition to returning to the six-nation talks only highlights its desperation,'' Quartersaw's Wei said. ``The regime is beginning to understand that a drastic change is needed for its survival.''

To contact the reporter for this story: Patricia Kuo in Hong Kong at pkuo2@bloomberg.net ; Lester Pimentel in New York at Lpimentel1@bloomberg.net