With three huge sovereign bond debuts, this has been a bumper year for emerging market government debt issues. First came Argentina, with a record-breaking $16.5bn (£13.5bn) sale in April, followed the next month by a $9bn issue from Qatar – double the amount it had originally planned for. Both were overawed last week, however, when Saudi Arabia sold $17.5bn in five, 10, and 30-year dated bonds to international investors. The bond was subscribed for a massive $67bn.
The demand was high, despite the Saudi and Argentine economies facing particular difficulties thanks to low oil prices and years of fiscal mismanagement respectively. So why have these issues been so well received?
The enthusiasm from investors owes in part to the hunt for yield. More than $10 trillion worth of bonds worldwide have negative yields, meaning that investors are effectively paying to hold them. The product of low inflation and rock-bottom interest rates, negative yielding debt can be found on two-year bonds in Japan and Germany, with the yield on short-dated US Treasuries not far into positive territory.
In comparison, the five and 10-year A-rated bonds issued by Saudi Arabia last week had yields of 2.37 and 3.25 per cent respectively, making them particularly attractive to investors in the current environment, especially to institutional investors such as pension funds and insurance companies.
Within emerging markets, Saudi Arabia and Argentina are arguably the ones with the most interesting reform momentum
But such an explanation overlooks the attractiveness of bond sales from two very reform-minded sovereigns which came to market with large placements, argues Alejo Czerwonko, emerging markets investment strategist at UBS Wealth Management. “Within emerging markets, these are arguably the ones with the most interesting reform momentum. You must also take into account the scarcity value of these securities,” he says. “Argentina hadn’t come to market properly in over a decade. And Saudi Arabia’s issue is the first placement of sovereign bonds in hard currency in the country’s history.”
Problems with pricing
Some investors were surprised at the pricing of the Saudi bonds, which had a tighter spread than the original guidance had indicated, and were aimed at both developed and emerging market investors. The bonds’ yield had been expected to come with a higher premium than similar-dated debt from the likes of Qatar and Abu Dhabi, which enjoy better credit ratings. Others see the 3.25 yield on the 10-year bond as being quite generous for an A-rated issuer. Indeed, it is not the 5 per cent which can be obtained in other emerging markets. But Paul Wetterwald, chief economist at Indosuez Wealth Management, points to Chile, another commodity exporter with an A+ rating, whose 10-year sovereign bond is yielding just 2.4 per cent. “Saudi is giving quite good value with respect to its risk profile,” he says.
“Many Asian investors are happy with the opportunity to put their money to work in a region with limited issuance,” says Nicolo Carpaneda, investment director in the fixed income team at M&G Investments.
The 30-year bond proved surprisingly popular with investors. But any debt with such a maturity comes with a degree of duration risk. If the US Federal Reserve hikes interest rates a number of times between now and 2046, holding such long-dated debt will look like a bad investment. But with the oil price so low, the real question is: will Saudi Arabia be good for it?
“The challenges for the Saudi sovereign remain ample in the years ahead, particularly in the context of a high break-even price of oil for a balanced budget and the need for further fiscal consolidation,” says Abbas Ameli-Renani, global emerging markets strategist at Amundi.
Oil accounts for three quarters of government revenues in Saudi Arabia, and the effect of a fall in the oil price has been dramatic. Embroiled in a costly war with Yemen, the days of a budget surplus, which the country enjoyed just a few years ago, look to be long over. Last year, the government ran a deficit of $98bn (15 per cent) and has been burning through its foreign exchange reserves to maintain its currency’s peg to the US dollar.
“In 2017, Saudi Arabia needs [the oil price to be] around $78 per barrel to balance its budget and around $60 per barrel to balance its current account, according to the latest IMF estimates,” says Simon Quijano-Evans, emerging markets strategist at Legal & General Investment Management. “The budget ‘break-even’ price has fallen from around $105 per barrel in 2014, highlighting numerous fiscal changes that the authorities have carried out.”
Indeed, the House of Saud’s commitment to reform appears genuine. All countries in the Gulf Cooperation Council have agreed to raise VAT from zero to 5 per cent, which marks an end to Saudi Arabia’s status as a no-tax regime, and should come into force before January 2019 at the latest. It is expected to generate an amount equal to 1.6 per cent of the country’s GDP, and is one of a number of measures, including the slashing of energy subsidies, which Deputy Crown Prince Mohammed bin Salman has outlined as part of Saudi Vision 2030 – his grand plan to diversify the economy and stimulate productivity by the end of the next decade.
“Saudi Vision 2030 is wishful thinking. It’s a nice glossy paper,” says Wetterwald. “But the country has a lot of young people and high demographic growth, so if it can translate this into higher productivity, it will be one of a few countries with very high potential.” Until now, Saudi Arabia has relied on large-scale immigration from countries such as India, while nationals enjoy cushy jobs in a bloated public sector funded by petrodollars.
Re-skilling and energising its workforce may be important to Saudi Arabia’s economic future, but it may not be necessary to meet its debt obligations down the line. “As it comes to mark-to-market of these bonds, oil price will be a very important factor,” says Czerwonko. “Whenever the oil price moves up, the bonds will probably rise in value. But under Saudi Vision 2030, there is a plan to balance their budget based on the current oil price."