Frontier issuers bring political risk to bond world

Wed Apr 9, 2014 6:01am EDT

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* Low-rated sovereigns jump into market

* Yields do not reflect political risks

* Political risk insurance fails to find favour

By Christopher Langner and Sudip Roy

SINGAPORE, April 9 (IFR) - Investors desperate for higher-yielding securities are snapping up bonds from speculative-rated countries, potentially ignoring their political risks in the process.

Pakistan, a country with a near-default rating from Moody's and a history of political and economic strife, sold $2 billion of US dollar-denominated bonds on Tuesday and paid less for selling a 10-year bond than Zambia, a slightly higher rated peer among so-called frontier credits.

The two-part offering was Pakistan's first in seven years and was sold a day after other junk-level credits, including Sri Lanka as well as Zambia, sold new bonds.

More offerings are expected from some of the most bottom-rung sovereigns as frontier countries attempt to beat an expected hike in funding costs later this year as US interest rates rise.

Ecuador, which defaulted on foreign debt in 2008 in spite of being able to repay, is in active discussions about a possible transaction, while even Ukraine is mulling the idea of a comeback in the second half of the year.

An emerging markets banker was unequivocal when asked whether investors are considering political risks when they buy frontier credit bonds. "No they're not," he said.

This is especially surprising given how political tensions in Ukraine, Russia, Turkey and Thailand have dominated headlines and roiled markets in recent months. Big elections also promise to shake up the political landscape in several developing countries, with Brazil and India among others, going to the polls.

WILLINGNESS TO PAY

Bond investors focus on the ability of a borrower to repay its debt. For sovereigns, that can easily be assessed with models that factor in fiscal policies, gross domestic product and inflation trends, among other public finance issues.

These models, however, do not take into account the willingness of the borrower to pay, a problem Ecuador highlighted when it defaulted. That is the essence of political risk.

"We are all good at relative value assessment but we not good at evaluating absolute risk," said an emerging markets portfolio manager at a US firm in Singapore.

The return of Pakistan to the global bond market just as the yield on its outstanding bond reached all-time lows, however, is forcing some investors to reflect on what kind of premium should be granted to a country where political legitimacy has been in short supply since it gained independence in 1947.

The bond also priced amid a flare-up in tensions related to a separatist insurgency in Pakistan's Baluchistan province, a sign that political conflict afflicts the country.

The problem of political legitimacy is not exclusive to Pakistan. Sri Lanka sold a 5.5-year dollar bond on Monday to yield 5.125%, the lowest coupon it has paid, although the country ended a decade-long civil war just four years ago.

On the day of the bond sale, Sri Lanka's foreign minister, Gamini Lakshman Peiris, told the United Nations the country would not cooperate with an investigation into potential war crimes in 2009. That was the year Mahinda Rajapaksa, the current president, led the dismantling of the Tamil Tigers and brought the civil war to an end.

Investor perception of Sri Lanka and Pakistan, though, are quite different. On Monday Sri Lanka achieved its tightest coupon on a dollar bond, which paid a yield about 250bp lower than what Pakistan paid for its five-year bonds.

Rajapaksa is widely expected to win the next general election, while Pakistan undertook its first democratic transition in its 66-year history in June 2013. Prime Minister Nawaz Sharif's PML-N party holds 190 seats in Pakistan's 341-seat parliament after a recent election.

Sharif, who has survived corruption allegations, imprisonment, exile and a military coup, is promising business friendly policies and moved quickly to sell dollar bonds for the first time since 2007. He also secured a US$6.7bn three-year loan from the International Monetary Fund last September.

Pakistan issued a US$1bn five-year bond yielding 7.25% and a US$1bn 10-year bond yielding 8.25% on Tuesday amid US$7bn in orders.

The 10-year note priced with a lower yield than the 8.625% Zambia paid on a US$1bn 10-year bond on Monday. Yet, Zambia is rated B+/B by Standard & Poor's and Fitch while Pakistan is rated Caa1/B- by Moody's and Standard & Poor's. Sri Lanka is rated B1/B+/BB-.

The three countries are at the lowest rungs of junk, but Moody's assessment of Pakistan is that default is a real possibility, while Zambia and Sri Lanka are a few more steps removed. That alone suggests that Pakistan's bonds should yield more than Zambia's.

At US$130bn, Pakistan's economy is about 13 times the size of Zambia's. But the African nation has been growing more than 5% a year, while Pakistan's average GDP expansion in the past five years has been 3.2%. Moody's predicts it will be 2.8% this year.

When Pakistan, began a roadshow earlier this month, a portfolio manager in London indicated the sovereign would have to pay double-digit yields to overcome the perception of political risk to get a deal done.

Another investor believed the final pricing did not accurately reflect Pakistan's risks. "We passed on the deal as we thought that it priced slightly too expensive given the potential downside risks surrounding the credit. We think that there is room for disappointment at this stage rather than further good news," said Anthony Simond, investment analyst, at Aberdeen Asset Management.

A hedge fund manager in Singapore questioned if the deal made sense at all. "I might as well buy Mongolia, which is offering 8% [in secondary markets]," the manager said.

The Singapore emerging market portfolio manager argued credit investors may not be pricing the political risk of the Mongolia correctly either. "We live in a relative value world," he said.

RATING POLITICAL RISK

Measuring political risk in addition to credit risk is not common in global credit markets, although banks that lend in frontier countries have long accounted for it. Large insurers, such as AIG, will insure banks against political risks typically by covering against such issues as expropriation, inconvertibility and political violence.

The cost of insuring one coupon payment on a loan could cost about 20bp a year, depending on the loan terms and the country involved.

Political risk insurance wraps, though, have never really taken off for bonds. "If you're an issuer and you go to market with a PRI wrap it sends a weak signal about your creditworthiness," said one banker.

Moreover, as the London-based banker pointed out, investors prefer to take their chances rather than buy a credit-enhanced product. "Emerging markets investors would rather be paid," he said.

Instead, fund managers rely on reports and statistics from the likes of the IMF and Eurasia Group to analyze a credit.

Country Insights, part of Roubini Global Economics, has begun to produce shadow ratings for lesser known countries to address this gap.

"We figured we needed to come up with a consistent way of measuring political risks," said Paul Domjan, managing director at Roubini Global Economics in London.

"We have an algorithm that takes into account more than 200 factors and offers us a shadow rating, which is then vetted by an analyst," Domjan explained.

The firm rates Pakistan four notches lower than Zambia, offering further proof political risk premiums are not being incorporated into bond prices.

For now, investors in these frontier bonds may want to brace themselves for a rough ride. Pakistan's bonds due 2017 reached yields as high as 25% in December 2008. Most of the volatility was a reflection of the wild swings in the country's internal and foreign politics, factors most investors are not used to evaluating. (Reporting By Christopher Langner and Sudip Roy; additional reporting by Davide Scigliuzzo; edited by Abby Schultz)

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